Far and above the most valuable liquidity ratio is the operating cash ratio. Unlike the other liquidity ratios that are balance sheet derived, the operating cash ratio is more closely connected to activity (income statement based) ratios than the **balance sheet**. Its primary element, the numerator in this formula is based on the income statement’s results on the cash basis method of accounting. This cash income is then divided by all **current liabilities**. The concept is simple; can the cash income over a period of time pay the current liabilities over the same period of time.

Of the 22 different core business ratios used in business analysis, this one is one of the top three most complicated. For one thing, the user must understand how cash flow from operations is calculated. Secondly, the perceptive user will want to know how is it that the very result of operating cash flows which is calculated from the change in current liabilities is then used to determine the ability to pay those current liabilities. It is like saying that you depend on ‘A’ to pay ‘A’. It borders on circular reasoning. Finally, a third issue complicating all this is the fact that cash flows from operations is also used to service debt, purchase **fixed assets**, add to **working capital** and reward investors for their risk taken on their investment. In reality, the higher this ratio the more lucrative and rewarding this investment. By the time you finish reading this chapter you will hold this single ratio in high regard if not the most critical of all ratios.

To educate the reader about this ratio, he must first understand how operating cash flow is calculated. Next this chapter explores the ratio as it relates to its relationship to current liabilities. Once the underlying fundamentals are understood, the next section explains how to use the ratio and apply it to businesses. Finally, this chapter introduces the broad application of the underlying operating cash flows and why this single value is the most important tool in analyzing small business and small cap investments.

This chapter in this series is an in-depth lesson about the operating cash ratio. More sophisticated and experienced business entrepreneurs may only need to read the first few paragraphs in each section to grasp the section’s goal. Others will have read the entire section to fully understand and apply the operating cash ratio. Use your judgement in how much to read as you progress with this chapter.

Contents

**Cash Flows From Operations**

Accountants use two different methods of accounting. They are:

**Accrual Accounting**– The preferred and legally required method for publicly traded companies. A set of rules known as Generally Accepted Accounting Principles (GAAP) eliminates timing issues and provides a more accurate indication of financial performance and status.**Cash Basis**– A simpler and less accurate method of accounting based on actual cash in’s and out’s of business. This method is typically used in**microbusiness**. Its benefits include low cost and ease of understanding actual performance.

Since most businesses use the **accrual method**, a third report in the financial statements converts accrual reports of the balance sheet and the income statement into a single cash basis report. This report is called the cash flows statement. This cash basis report is split into three sections.

**Cash Flow From Operations**– This is the heart of the company’s financial picture. The report identifies how well the company generates cash from its core purpose.**Cash Flow from Investing**– This section of the cash flows report focuses on fixed assets. How much was purchased (outflow) and monies received for the sale of fixed assets (inflows). In growing and expanding businesses, especially small cap companies, this section is almost always a negative (outflow) value. This is due to the purchasing of fixed assets.**Cash Flow from Financing**– This third section identifies the capitalization aspect of the company. In most cases, this value is positive as most businesses borrow money (inflow) and/or sell equity via stock (inflow). Typical outflows include principal payments on debt and dividends to investors. Interest on debt is a function of cash flow from operations.

For those readers familiar with cash flows from operations and how it is calculated, stop here and move onto ‘Operating Cash Flow and Current Liabilities’, the next section.

The cash flow operations converts the accrual net profit into the actual cash earnings for the period in question. The basic formula is:

Accrual Net Profit $ZZ,ZZZ

Plus/Minus Any Noncash Deductions on the Income Statement Z,ZZZ

Plus/Minus The Change in Current Assets Net of Cash Z,ZZZ

Plus/Minus The Change in Current Liabilities __ Z,ZZZ__

Cash Flow From Operations $ZZ,ZZZ

Although this appears simple, it is actually quite convoluted as the formula steps are independently explained below.

**Step One – Start with Net Profit and Add Back Non-Cash Expenses**

The formula always starts with net profit, i.e. the bottom line from the income statement (profit and loss statement). This net profit value is always after capital cost expenses of depreciation and amortization. Furthermore, the net profit is a result of allocations to the income statement including allocation of long-term warranties, long-term prepaid technology costs and insurance. Notice only long-term prepaid expenses are included here. Short-term prepaid are actually a function of current assets in Step Two below. The following is a condensed version of this step.

Take the Net Profit $ZZ,ZZZ

Add Back: __Balance Sheet Section
__ Depreciation $Z,ZZZ Fixed Assets

Amortization ZZZ Other Assets

Warranties (Allocation) ZZZ Other Assets

Long-Term Prepaid

__Z,ZZZ__Other Assets

Subtotal

__Z,ZZZ__

Balance Forward to Step Two $ZZ,ZZZ

Sometimes there are subtractions, but this is rare. Subtractions may include pre-paid billings (long-term only) or deposits converted to sales. With small business this so rare because many accountants do not know how to track this for bookkeeping purposes. Therefore, the original transactions are usually included in the income statement or in current liabilities.

At the end of Step One, the value is considered operational cash flow provided there are no changes to current assets or current liabilities. In reality, there are always changes to these two balance sheet sections.

**Step Two – Add or Subtract Current Asset Changes**

Current assets typically comprise four assets as follows:

– Cash – Accounts Receivable

– Inventory – Prepaid Expenses

The goal of the cash flows statement is to account for the change in cash. This particular asset of the current assets group is excluded in calculating the change in current assets. To calculate the change in current assets, the reader gathers information in the form of the beginning and ending balances for the respective current assets. The beginning balances reflect the start of the accounting period used. Most operating cash ratios are stated for an entire year. Therefore, the beginning balance is last year’s ending balance. By determining the change over one year, the user can aggregate the individual changes to determine total change in current assets excluding cash. Here is an illustration.

**ACME ROADRUNNER TRAPS**

Comparative Balance Sheets (Limited Scope)

Periods Ending December 31, 2015 and 2016

__Current Assets__ __12/31/15__ __12/31/16__ __Difference
__ Cash $72,714 $79,642 $6,928

Inventory 17,409 15,657 (1,752)

A/R – Wyle E. Coyote 42,643 49,714 7,071

Prepaid Expenses

__4,614__

__4,279__

__(335)__

Total Current Assets $137,380 $149,292 $11,912

Exclude Change in Cash

__(6,928)__

Change in Current Assets for Use in

Determining Cash Flow From Operations $4,984

This is the part that throws most accountants, finance directors and investors into a rage. Do I add or subtract this value from the adjusted net profit in Step One? Well to answers this, let’s think about current assets in isolation. If assets increase, how did they increase? Obviously cash must have been used to buy the assets. If cash is used then it must be subtracted from the value in Step One. Remember the cash in the cash account is excluded as illustrated above. The cash flows statement is trying to account for the total change in cash. Think about the above, to increase assets, ACME had to pay for them. So it uses cash to do this. If this final change were negative, it would be no different then selling them and receiving cash. For example, suppose their customer Wyle E. Coyote paid down his balance to $38,643, then ACME received cash of $4,000. Thus, if this were they only change in current assets, then this $4,000 value would be added to the adjusted net profit from operations.

**Step Three – Add or Subtract Changes in Current Liabilities**

This step is easier than Step Two because there are no exclusions. Current liabilities are easy to understand. A liability means the business is borrowing money. There are two groups (forms) of liabilities, long and short term. Long-term debt is handled in the cash flow from financing section of the cash flows statement. Whereas, short-term liabilities are addressed with cash flows from operations. This separation of long and short term liabilities exists because short-term debt relates directly to operations. Long-term debt is almost always a function of purchasing fixed assets. Here is a list of short-term liabilities:

- Accounts Payable
- Credit Card Accounts
- Accrued Expenses (most common is payroll and employee benefits earned)
- Taxes Payable (income, revenue, payroll and property)
- Lines of Credit

All five accounts are a direct reflection of current operations. For example, as a company pays the employee, the employee earns rights to benefits such as vacation time and healthcare. The company owes the amount as an accrued expense which is deducted as an expense under accrual accounting. The same is true for purchases of materials and supplies via vendors as posted to the accounts payable. Taxes payable include payroll taxes withheld from employees and matching taxes (Social Security and Medicare). Other taxes include revenue, property and of course income taxes (federal and state). These are deducted as expenses on the income statement and have yet to have the check cut to pay them.

The normal pattern for current liabilities is to expand (increase) in the aggregate as a company prospers. More mature and high profit margin operations tend to reduce the aggregate current liabilities over time. But just like current assets, the user of information needs both the beginning and ending balances covering the time period of the income statement. Here is an example:

__Current Liabilities__ __12/31/15__ __12/31/16__ __ Difference
__ Accounts Payable $21,417 $26,209 $4,792

Credit Card Accounts 3,008 2,593 (415)

Accrued Expenses 7,447 8,288 841

Taxes Payable 5,033 712 (4,321)

Lines of Credit

__12,000__

__9,000__

__(3,000)__

Total Current Liabilities $48,905 $46,802 ($2,103)

Is this decrease in current liabilities a cash inflow or outflow?

Remember, if liabilities increase, it is the same as borrowing money (inflow). In the above case, current liabilities decreased meaning the business paid down or paid off debt which is a cash outflow.

Going back to the original cash flow from operations formula, the three steps are:

- Add back non-cash items in the income statement to the net profit including depreciation, amortization and allocation of warranties and other prepaid long-term costs.
- Add any decrease in current assets excluding cash OR subtract (cash was used) any increase in current assets.
- Subtract any decrease (reduction of short-term liabilities, i.e. paying back current liabilities) of current liabilities OR add any increase (borrowing more) in current liabilities.

This is the basic formula for determining operating cash flow. If you need more help or another perspective, please read the following articles:

**Cash Flows – Introduction****Cash Flow From Operations – Basic Formula (Part I)****Cash Flow From Operations – Understanding Cash Flow (Part II)**

Notice how in this cash flow from operations formula current liabilities are a function of this formula, yet the operating cash flow ratio is used to determine the ability to pay current liabilities. There is a relationship here and it is important for the reader to understand this relationship.

**Operating Cash Flow and Current Liabilities**

The primary purpose of the operating cash ratio formula is that it measures the ability to pay current liabilities from operations. Owners, managers, creditors and investors all want assurance that the core business operation can pay the current bills. This appears simple. But it is flawed.

Suppose current operations cash flow is $12,000 and the current liabilities are $4,000. This means the cash flow from operations can easily cover current liabilities three times. The problem is that cash flow from operations is a derivative of current liabilities. This means the change in current liabilities determines the amount of operating cash flow that in turn determines the ability to pay those same current liabilities. Let’s clarify with an example.

In this situation, using the information from above, suppose the current liabilities increased from $2,000 to $4,000 during the operating period. From the formula above this means the company borrowed $2,000 during the operating period. The formula states that when current liabilities increase, add any increase in current liabilities, see Step Three. In reality, the operating cash flow was $10,000 (net of the current liabilities increase). If you adjust the formula to exclude the current liabilities increase the ratio drops from 3:1 to 2.5:1.

Operating Cash Ratio (Excludes Increase in Current Liabilities) = __$10,000__

$4,000

Operating Cash Ratio (Adjusted) = 2.5:1

Notice that with this adjusted formula, the denominator (current liabilities) stays at $4,000 reflecting the balance currently not adjusted.

This is a big difference than a 3:1 ratio. It would appear the formula is flawed. Or is it?

For those readers already experienced with the business relationship, stop here and proceed to the next section ‘Uses and Application of the Operating Cash Ratio’.

The ratio’s internal flaw is this change in current liabilities. More sophisticated business investors and entrepreneurs will exclude any increases in current liabilities during the period in calculating operating cash flow. Decreases are still included as they negatively impact cash flow from operations (a decrease in current liabilities during the accounting period is via the use of cash to pay down current liabilities therefore decreasing operational cash flow). It is a more conservative approach. Here is an illustration.

Sampson is an oil drilling enterprise with 18 rigs. During the month of June, Sampson’s operating cash flow as reported on the cash flows statement was $211,000. The current liabilities increased from $137,000 to $153,000 during June. Sampson’s management uses the traditional operating cash ratio and the adjusted operating cash ratio (excludes an increase from cash flow from current liabilities) to report the results. Here is the analysis.

** SAMPSON DRILLING**

Operating Cash Flow Ratio Analysis

June 20ZZ

** Operating Cash Ratio Operating Cash Ratio**

** Traditional Formula Adjusted Formula**

Cash Flow From Operations $211,000 $211,000

Adjustments -0- (16,000) Increase in C/L

Adjusted Cash Flow From Ops

__$211,000__

__$195,000__

Divided by Current Liabilities $153,000 $153,000

Operating Cash Ratio 1.38:1 1.27:1

The adjusted cash ratio (excluding any cash flow increase due to current liabilities increase) is always lower than the traditional formula.

Sophisticated users of the ratio take a more conservative position with its use and only adjust for increases in current liabilities (borrowing money) to get a value that reflects the ability to pay current liabilities from operating income as if that operating cash income had never increased its value due to short-term borrowings.

Always remember, the adjusted operating cash ratio can only be lower than the traditional value. It is only used when current liabilities increase during the accounting period because increases in current liabilities increase operating cash flow.

What is interesting is that this relationship issue remains linear when calculating this operating cash ratio with very small business environments through large operations. Let’s compare the operating cash ratio for a Mom and Pop auto repair shop to a chain network of 20 shops. Both have a 10% increase in current liabilities during the accounting period.

** Mom & Pop Medium Chain (20 Shops)**

** Auto Repair Network Auto Repair Chain**

Operating Cash Flow $42,000 $840,000

Increase in C/L (10,000) (200,000) Factor of 20

Adjusted Cash Flow

__32,000__

__640,000__

Current Liabilities 22,000 440,000 Factor of 20

Adjusted Operating Cash Ratio 1.45:1 1.45:1

Normal Operating Ratio 1.91:1 1.91:1

The other liquidity ratios do not have a similar linear relationship. This is because they are purely balance sheet driven and this ratio incorporates the income statement and its relationship with one section of the balance sheet (current liabilities). This utilization of both financial statements requires the user to be more alert and attentive to the derivative.

At the end of the day, the operating cash ratio is not a pure liquidity ratio, it is more a hybrid between activity ratios (the next section group of ratios) and liquidity ratios.

Now that the reader has an understanding of the operating cash ratio, it is time to explain the uses and application of the operating cash ratio.

**Uses and Application of the Operating Cash Ratio**

The operating cash ratio is designed to evaluate the ability of a business to pay its current liabilities from excess cash flow. This is important to understand. In general, current liabilities consist of three significant types of liabilities:

**Accounts Payable**– Vendor accounts used to purchase materials and subcontractors tied to the cost of goods sold (cost of sales). During a typical month the accounts will refresh as materials are purchased for the current month’s sales.**Credit Card Accounts**– Management customarily relies on a third-party creditor to cover various expenses from fuel to office supplies. Just like accounts payable, these accounts refresh monthly.**Accrued Expenses**– These costs are tied most commonly to payroll and their corresponding taxes along with benefits for the employees. Since labor is a significant component of both cost of sales and overhead operations, it too is refreshed monthly.

The three primary current liabilities mostly follow a similar pattern each month. Sales of products and services provide the cash to pay the bills. The aggregate balance of payables tend to move with the growth of the company. Operating cash flow really represents excess cash (technically not profit) which has a high correlation to profit from operations. Therefore the primary use of operating cash flow is to evaluate how fast (soon) the company could pay off current liabilities. A 1:1 ration means the company can pay off current liabilities in one accounting period, if it needed to pay them off that quickly. In reality, the operational flow should pay the existing bills as identified above. Operating cash flow of 1:1 or greater simply means the company can elect to carry a very low balance of current liabilities in less than one accounting period by using excess cash to pay down liabilities.

Here is a table of time frames to extinguish current liabilities based on the ratio:

Monthly Accounting Period Yearly Accounting Period

__Ratio__ __Period of Weeks__ __Time Period__

5:1 < 1 Week 11 Weeks

4:1 1 Week 3 Months

3:1 < 2 Weeks 4 Months

2:1 2 Weeks 6 Months

1:1 1 Month (4 Weeks) 12 Months

.8:1 5 Weeks 15 Months

.5:1 2 Months 2 Years

.25:1 4 Months 4 Years

.2:1 5 Months 5 Years

Please remember, the ratio is stated on an annual basis for publicly traded business and on the quarterly or monthly basis in small business. A reader of the ratio will always ask ‘Over what accounting time frame is the ratio calculated?’

The operating cash ratio is really a sign of ability to generate extra cash. Wise business owners use extra cash to reduce debt. Debt reduction always starts with current liabilities. A one to one ratio means that the company generates enough cash to reduce or eliminate a current liability balance within a comparable accounting time frame. However, paying off debt is not always the priority with earning cash.

Often extra cash is used to increase working capital first. Increasing working capital by simply adding more cash to the bank account improves the current, quick and the cash ratio. In addition, it adds depth of time to address lean operating periods. Finally, any entrepreneur must be practical with using this extra cash.

Better operations use the extra cash to make principal payments on debt; principal payments on debt are a function of cash flow from financing, i.e. it reduces overall cash. In addition, growing businesses must expand fixed assets too. Often fixed asset purchases, a function of cash flow from investing, require down payments along with borrowing money. Because of the 2008 mortgage fraud debacle, banks and asset lenders now require 25% to 45% down payments on purchases of fixed assets. This cash has to come from either investor equity or cash earned from ongoing operations. Anytime the operating cash flow ratio exceeds 1:1 over an entire accounting year, the investor is looking at a reasonable performing operation. See my caveat below.

**Caveat** – Most small businesses have current liability balances in the aggregate of 30% or more of total assets. The remaining balance of assets are financed with long-term debt and equity. A good operating cash ratio has the ability to improve the financial position significantly in a small business.

Having a ratio of less than 1:1 doesn’t mean the operation is performing poorly, it could mean that either current liabilities is very high as a percentage of total assets or the operating cash flow relied heavily on an increase in current liabilities (see the section on the relationship of operating cash flow and current liabilities above). Naturally the higher the ratio the more lucrative the business operation. Whenever the ratio is less than 1:1 and there is more 40% asset value in aggregate current liabilities, look for solvency issues.

Below is an appropriate step by step procedure and an IF/THEN application for the operating cash flow ratio.

STEP ONE – Identify the accounting period of coverage. In publicly traded stocks it is always stated on an annual basis. For small businesses it is customary to use more frequent periods of quarters or months. The ratio should be converted to an annual value for analysis.

STEP TWO – Look at the change in aggregate current liabilities. Did this change increase or decrease during the accounting period? If it decreased, move onto STEP THREE. If it increased, did this increase account for more than 20% of the operating cash flow? If yes, recalculate the ratio based on the formula used by eliminating the cash from the increase in cash flow attributable to the increase in current liabilities as explained earlier. Then recalculate the ratio as the adjusted cash ratio as illustrated above. Then move onto STEP THREE. If no, move onto STEP THREE.

STEP THREE – Compare the aggregate current liabilities as a percentage of total assets and apply the ratio.

- If the total current liabilities as a percentage of total assets is less than 10%, STOP, this ratio has very little meaning or use because the current liabilities are so insignificant it will naturally inflate the ratio’s results due to the fact that current liabilities is the denominator in the formula.
- If aggregate current liabilities is more than 65% of total assets and the ratio exceeds 1:1, use more activity ratios to confirm financial capacity to reduce overall current liabilities. If the ratio is less than 1:1, under these conditions then most likely the business has solvency issues.
- If total current liabilities are between 10% and 65% of total assets then use the following guideline in evaluating the ratio:

< or Equal to 1:1 – Extreme caution should be used as the company will have cash flow issues and an inability to service current liabilities. Any form of strain from lack of cash collections could cause bankruptcy.

>1:1 < or Equal to 3:1 – This is acceptable as a liquid operation but caution is appropriate. Look for available options for short-term cash to fill voids in case of slow payment (cash collection) periods. Examples include lines of credit or if the business can utilize a long-term loan to reduce short-term debt.

> 3:1 – Indicates adequate cash flow from ongoing operations to service current liabilities, improve working capital and address principal payments and return on investment for owners.

**Summary – Operating Cash Ratio Formula and Understanding**

The operating cash ratio is used to evaluate the ability of a company to meet is short-term obligations. It is a hybrid of liquidity and activity ratios. Its formula is inherently flawed as one of the elements of cash flow from operations is the change in current liabilities. More sophisticated investors and users of the ratio will adjust the result for any increase in current liabilities to determine a more conservative outcome.

Use the formula when the aggregate current liabilities balance is between 10% and 65% of total assets. Any value of 3:1 or higher indicates adequate cash flow to service all debt and still contribute to working capital. Values between 1:1 and 3:1 require caution and application of other solvency related ratios such as cash and quick ratios. If less than 1:1, the investor or management team must proceed with caution as any form of restricted cash flow will create serious solvency problems and possibly bankruptcy. **ACT ON KNOWLEDGE**.