The Operating Cash Flow Ratio explained.

The OCF Ratio (coverage ratio) is a liquidity ratio that measures whether a business generates enough cash from its core operations to pay off its short-term obligations (Current Liabilities). As an investor, assessing a company’s short-term liquidity can provide valuable insights into its financial viability.

The OCR ratio indicates how much a company earns from its operating activities for each dollar of current liabilities. Investors want to know if a company can meet its short-term obligations with its operating cash flow. A higher OCF ratio implies a stronger liquidity position, reducing the likelihood of debt or dilution. It is a good sign that a company has the cash flow to cover its short-term dues.

Short-term liquidity is a crucial focus for investors seeking to minimise risks associated with investing. Finding companies with strong financial positions is one way to do this.

This liquidity ratio is considered a very accurate measure of short-term liquidity. It uses cash generated from core business operations rather than other easily manipulated income sources.

If the OCF Ratio is greater than one, the company will have generated enough cash to pay off all its current liabilities for the year. However, an OCF ratio of less than one indicates that the business has not generated enough to cover its current liabilities.

What is the Operating Cash Flow Ratio formula?

• OCF Ratio = Cash Flow from Operations ÷ Current Liabilities
• Operating Cash Flow = Found on the Cash Flow Statement and usually is a top line item.
• Current Liabilities = Found on the Balance Statement.

Operating Cash Flow is the cash generated by the core operating activities of the business, such as selling products or services, paying suppliers, and managing inventory. OCF only relates to normal business activities to determine whether a company has sufficient cash flow to operate and expand. Cash Flow from operations is the cash equivalent of net income.

Current Liabilities are debts and obligations due within one year, such as accounts payable, taxes, and short-term debt.

How to use the OCF Ratio?

When considering a company’s financial health, I find the Operating Cash Flow ratio to be a useful indicator. However, I don’t rely on it solely for industries or company-to-company comparisons. Instead, I use it more as a tool to evaluate potential investments and monitor existing holdings.

In particular, for early-stage or hyper-growth companies, I keep a close eye on the ratio to ensure that there are no short-term challenges that might arise.

Ideally, a higher ratio indicates that the company has efficient management of capital, cash flow, and short-term obligations. However, a lower ratio doesn’t necessarily mean that the company is in poor financial health.

As an investor, we must dig deeper to understand why the ratio is low. For example, if a company is making strategic investments that impact short-term cash flow but create long-term value, then a low ratio is warranted.

In our example today, let’s dive into one company to determine the OCF ratio and how we can interpret this.

Company A	2021	2022	2023
Cash Flow Statement
Net Income	$287 million	$325 million	$407 million
+ D&A	$45 million	$48.5 million	$56 million
– Change in NWC	($22) million	($30) million	($33.8) million
Operating Cash Flow	$310 million	$343.5 million	$429.2 million
Balance Sheet
Accounts Payable	$65 million	$67.8 million	$71 million
Taxes	$32 million	$36 million	$41 million
Short-Term Debt	$63 million	$61.5 million	$62.8 million
Total Current Liabilities	$160 million	$165.3 million	$174.8 million
OCF Ratio	1.93x	2.07x	2.45x

In this simplified example, using horizontal analysis can help us see how the ratio is evolving. The OCF ratio in 2023 is 2.45x which translates to the business having $2.45 operating cash flow for every $1 current liabilities. So, it can cover short-term obligations 2.45 times over. This indicates a very healthy number.

The way to look at this is Company A has generated more cash to cover current liabilities and still has earnings left over for reinvestment opportunities.

In Summary…

When using the OCF ratio, I consider my own business experiences and how helpful having positive cash flow was during tough times.

A high ratio indicates that a company’s short-term liabilities are well-covered by cash flow, which signifies a strong underlying business. Higher ratios also allow operators to accelerate debt repayments, cover expenses, invest in growth opportunities, and create shareholder value. As a company matures, maintaining a high coverage ratio enables it to pay dividends and initiate share buybacks.

If I observe a negative or declining OCF ratio in any of my holdings, I investigate immediately. If a company is unable to generate sufficient revenue from its core business operations, it must fill the cash flow gap through financing or by delaying investment activities.

I analyse whether this is a temporary or long-term issue. If it’s a one-time negative quarter, it could be due to an investment made, unusual expenses, or accounts receivable issues.

However, if it’s a long-term trend, I avoid such companies. A business without excess cash on hand may make poor operating decisions, take on unnecessary debt, or dilute its shares into oblivion.

This ratio is something I use alongside other “Operating” Ratios such as Operating Leverage and Operating Margin. In my own analysis I pay a lot of attention to the core operating business to determine how this company can scale and create value over a decade.

Long-term investing requires quality and risk mitigation. Companies with negative OCFs can survive, but financially viable opportunities are better for compounding capital.