Introduction
Cash flow as the name suggests is the flow of cash in and out of business. It is a very important metric that is used to measure the viability and thrivability of a company. There are many types of cash flows. One of these is the cash flow from operation. This is defined as the cash flow generated or consumed by a business as a result of its operation. It is one of the most important aspects of a cash flow statement in the balance sheet of a business.
Even the most profitable businesses can have real issues with the cash flow. So, with profitability cash flow from operations is another important metric that is used to measure the efficiency of an operation of a company.
The operations which impact the cash flow of a company are paying suppliers, expenses, salaries, and funding working capital.
The cash flow from operation ratio measured this exact value. The cash flow from operation ratio measures whether the cash flow is adequate for a company to carry out its operations. This ratio measures whether the company is generating enough cash flow from its operations to meet its liabilities.
Example
There are many types of cash flow from operation ratio; one of the most used ratios is the Cash return on assets ratio. Take, for example, a company that is generating a cash flow of fifty thousand dollars from its operations, and its assets are worth ten thousand dollars.
Now, to calculate the cash return on assets ratio, just divide the cash flow from operations with the net value of the assets.
Formula = cash flow generated from operations/ value of the assets
Now, for Company = 50,000/ 10,000 = 5
So, the cash return on assets ratio for this particular company is 5.
3. Types of cash flow from operations, their formulas and measurement
There are many types of cash flows measured from operations. The main types of cash flows from the operation are given in figure 1 below:
Figure 1: Main types of cash flows from the operation
The three main types of cash flows from the operation are given in figure one. The three types are Cash flow to enterprise value, Cash flow operation to return on assets value, and cash flow operation to debt ratio.
3.1 Cash flow operation Enterprise multiple
This metric compares the cash flow a business is generating to its Enterprise value. This metric is used by analysts to identify opportunities in companies that are being undervalued by the market. It is a very useful metric that is used by many people in the industry.
The Enterprise value is known as the combined value of all the liabilities and assets of a company. In simple words, it is the current market value of a company.
The cash flow enterprise multiple is used by the private equity firms to calculate how much time it would take for a firm to generate enough cash flow to buy out the firm at its current market value.
The lower the enterprise ratio, the more attractive a firm appears to its buyers, especially buyers from private equity.
3.1.1 Formula of Enterprise multiple
The formula of enterprise multiple is as follows:
E.M = E.V / C.F.O
Where E.M = enterprise multiple
E.V = Enterprise value
And C.F.O = cash flow from operation
3.1.2 Example
Let’s take for example a firm that is generating annual cash flows of one million dollars, and its enterprise value is ten million dollars. Now to find the enterprise multiple, we use the formula stated above, and
E.V= 10,000,000/ 1,000,000 = 10
3.2 Cash flow operations to return on assets
This is another important measurement metric that helps explain how efficiently a company is using its assets to generate cash flow. The higher the return on assets, and the higher the cash flow from the operation, the higher would be the value of this metric.
Companies regularly use this metric to identify the places in their operations where they could increase operational efficiency. This is a metric that is also used by investors to understand how good a company is at using its assets.
3.2.1 Formula for calculating return on assets
Cash return on assets = cash flow from operations/ total assets
3.2.2 Example
Take, for example, a company that is generating a cash flow of fifty thousand dollars from its operations, and its assets are worth ten thousand dollars. Now, to calculate the cash return on assets ratio, just put the values in the given formula in 3.2.1.
Now, for Company = 50,000/ 10,000 = 5
So, the cash return on assets ratio for this particular company is 5.
3.3 Cash flow operations to debt ratio
Cash flow from operations to debt ratio is used by the management of a company to forecast how much time it would take for a company to repay its debt just from its cash flows. This metric is also used by analysts to get a grasp of how much healthy a company’s financial position is. The lower the ratio, the less debt the company has, and the healthier its financial position is.
3.3.1 Formula
The formula for cash flow operation to debt is as follows:
Cash flow to debt ratio = cash flow from operations / the total outstanding debt of the company
3.3.2 Example
Consider a company called ABC, it wants to calculate its debt ratio for future planning. The cash flow generated from its operation is one hundred thousand dollars, while its total outstanding debt is one million dollars.
Now, its debt ratio is, by putting these values in formula stated in 3.1.1, we get
Cash flow to debt ratio = 100,000/ 1,000,000 = 0.1or 10%.
So, it would take about ten years for the company ABC to pay all its outstanding debt.
4. Conclusion
The cash flow from operation ratio is a very important metric used by financial analysts, and even companies themselves to evaluate their performance, and find undervalued enterprises, while also identifying where they can improve their operations.
