What is the Cash Flow to Sales Ratio?
The cash flow to sales ratio reveals the ability of a business to generate cash flow in proportion to its sales volume. It is calculated by dividing operating cash flows by net sales. The operating cash flows information can be extracted from a firm’s statement of cash flows, while its net sales can be found near the top of its income statement.
Ideally, the ratio should stay about the same as sales increase. If the ratio declines, it can be an indicator of a number of problems, such as:
- The firm is pursuing incremental sales that are generating a smaller amount of cash.
- The firm is offering incremental customers longer payment terms, so that cash is tied up in accounts receivable.
- The firm must invest in more overhead as its sales increase, thereby reducing the rate of growth in cash flow.
All of these issues can indicate that a business is growing its sales at the expense of declining cash flows.
Cash Flow to Sales Ratio is a performance metric that represents a business’s operating cash flow once all capital expenditures related to sales have been deducted. Cash flow is an important element in evaluating a company’s financial state and intrinsic valuation.
The Cash Flow to Sales Ratio should be recorded during a period of time and be compared with other companies’ numbers for it to provide meaningful insights and understand implications more clearly.
As with other financial ratios, the Cash Flow to Sales Ratio should not be interpreted by itself. Instead, it should be compared with other financial ratios, such as Return on Assets, Price to Earnings, and the rest. Also, it must be monitored over a particular period of time instead of merely a specific time so that patterns can be gleaned and used to control the company’s future movement.
Cash Flow to Sales Ratio Formula
In order to calculate the cash flow to sales for a company you would like to evaluate, you can use the following formula:
Cash flow to sales ratio = Operating cash flow ÷ Net sales
Cash flow is the amount of cash left after a company’s capital expenditures have been deducted from its operating cash flow. All numbers required to compute for cash flow are found in the financial statements of the business being investigated.
- Used Over a Period of Time: Conclusions must not be drawn based on a single number. A company may be able to convert its sales to cash for one year. But it is consistent, sustained record to do so that makes it more valuable.
- Cash Flow Should Move In Direction And Proportion With Sales: If the sales are genuine, the cash flow will move more or less in correlation with the sales figure. The direction of movement and the quantum of change must be highly correlated with the sales figures.
- Earnings Have Not Been Manipulated: As has been discussed many times before, earnings are subject to easy manipulation by the management. Thus if the management changes the policies from one year to another, then the numbers are just not comparable.
- Cash Flow Has Not Been Manipulated: The total cash flow cannot be manipulated. However, companies have got innovative and have indeed shifted cash flow from financing and investing sections to the operating section. Thus analysts need to be wary of such accounting tricks at play to make the numbers look better than they are.
- Are The Company’s Sales Genuine: The operating cash flow to sales ratio provides the analyst insight into the sales of the company. It is a known fact that companies can fudge the sales number relatively easily. This can be done by changing the revenue recognition policy which allows accountants to book future income as income today. Sometimes companies do fake transactions to ensure that sales numbers look good to the stock market. However, the acid test comes when sales need to be converted to cash. Only genuine sales bring in cash flow. Thus analysts can make more accurate prediction of the future years cash flows and therefore value the stock more accurately.
- Compare With Days Sales Outstanding: The operating cash flow to sales ratio should also be somewhat in line with the days receivables outstanding ratio. For instance if 90 days receivables are outstanding, it means on an average the company extends credit for (90/360), 25% of its sales at any given point of time. Thus in this case the operating cash flow to sales ratio must be 75% or close. This makes the analysts more sure that the financial statements of the firm are indeed genuine.
Cash Flow to Sales Ratio Analysis
Although there are some small variations in the way companies calculate their cash flows, the Cash Flow to Sales Ratio is usually determined by removing capital expenditures from operating cash flows. Yearly capital expenditures are necessary to maintain an asset base and prepare for future growth.
Cash flow is important to the company and its owners because this money will dictate the size of dividends that can be distributed among shareholders and the reduction of shares outstanding by buying back shares (thereby raising earnings per share, granted that all other values are unchanged), as well as decide on acquisitions that build on the company’s expansion plans. The way a company handles cash flow is part of its capital distribution policies.
Clearly, the more cash flow a company has, the healthier its financial position is. In general, a ratio greater than five percent is favorable because it shows that a company has a great ability to generate enough cash to fund its growth. This will also be good for the company’s image, especially in the eyes of shareholders. However, if a business’s revenue is all spent on capital expenditures and leaves almost nothing to fund growth, then there is no reason to be complacent.
Cash flow is essentially cash that the company is has once all its operating costs have been settled. This is the money used by the business to pay for its debts and other financial obligations, distribute dividends among shareholders, or reinvest for growth. Therefore, the bigger the cash flow, the better. The higher the Cash Flow to Sales Ratio, the more ability a company has of turning its sales into really matters at the end of the day: cash. Monitoring trends and comparing ratios with other parallel companies also provides clues into the market competitiveness of the business.
Remember that Cash Flow to Sales Ratios must be tracked over a certain length of time when a company is rapidly growing. Hence, negative or low cash flow is not always a sign of trouble. It could simply mean that the business is investing heavily to prepare for an expected increase in demand. The ratio may low or even negative for a year or two, but is likely to increase and stabilize soon after.
Even though cash-based ratios are often more accurate, remember that a company’s total cash flow is very easy to manipulate. Also, keep in mind that the Cash Flow to Sales Ratio is not the only way to evaluate a company’s fiscal health.
By itself, it should be used merely as a sign that the business’ financial status must be investigated further. If other areas appear to be doing fine, then it is safe to say that the business is financially stable.
Cautions & Further Explanation
From another perspective, the operating cash flow to sales ratio can also become a good indicator of how efficient a business is in terms of collecting money from its customers.
It should be noted that a company’s operating cash flow should be in correlation with its sales revenue. If the business reports a growth in sales, there should also be a growth in operating cash flow.
Your business is raking in the sales, but it may not necessarily be bringing in cash flow – this is the problem!
In fact, sales can be easily inflated by a company by changing its credit policy, thereby encouraging more customers to buy on credit.
Not only this makes the sales increase significantly, but also the accounts receivable.
If the sales increases dramastically while cash flow does not increase or remain the same, this may be a warning sign that the business is facing troubles when collecting money from its customers.