Having a full understanding of your company’s cash flow is one of the best ways to gain a deeper insight into your business’s financial health. By coupling cash flow with sales, you can find out just how efficient your company is at turning operations into cash. How? Through the cash flow margin formula. Learn more about cash flow margin ratio analysis with our definitive guide.
What is operating cash flow margin?
Operating cash flow margin is a profitability ratio that measures your business’s cash from operating activities as a percentage of your sale’s revenue over a given period. Put simply, it’s a demonstration of how well your business is able to convert sales to cash. Cash flow margin ratio analysis is vital for companies to get to grips with, providing insight into your business’s profitability, as well as the quality of its earnings.
How to do a cash flow margin calculation
To work out your company’s operating cash flow margin, you’ll need to know a couple of key pieces of information, including net income and change in working capital. Here’s a simple cash flow margin formula you can use:
Operating Cash Flow Margin = (Net Income + Non-Cash Expenses (Amortization and Depreciation) + Change in Working Capital) / Sales
Cash flow margin example
So, how does the cash flow margin formula work in practice? It’s relatively straightforward, so here’s a cash flow margin example to shine a light on the practical applications.
In 2019, Company A had a net income of £500,000, while non-cash expenses worked out to £25,000. In 2018, their working capital was around £200,000, but at the end of 2019, it had increased to £220,000, giving them a change in working capital of £20,000. Finally, they had sales of £900,000. So, using the cash flow margin formula, we can determine Company A’s operating cash flow margin like so:
(£500,000 + £25,000 + £20,000) / £900,000 = 0.6 x 100 = 60%
So, what does that mean in real terms? Well, while there’s no one-size-fits-all ratio that your business should be aiming for – mainly because there are significant variations between industries – a higher cash flow margin is usually better. A cash flow margin ratio of 60% is very good, indicating that Company A has a high level of profitability.
What does cash flow margin ratio analysis tell you?
The operating cash flow margin measures the efficiency with which your company turns sales into cash. Because cash flow margin is based on transactions involving money that has actually been transferred, rather than projections, it’s an especially good indicator of earnings quality. In addition, cash flow margin ratio analysis can be a great way to compare competitors within the same industry, as cash flow itself is driven by operational efficiency, overheads, and revenues.
Limitations of the cash flow margin formula
When looking at cash flow margins, it’s important to remember that companies will often adjust cash flows from their operations voluntarily. For example, they may delay payments to accounts payable or deplete inventory, thereby retaining more cash within the business. If you’re an investor using cash flow margin ratio analysis to evaluate a company, it’s worth looking at cash flow margins over an incremental period of time, as this is likely to provide a much more comprehensive overview of the business’s profitability.
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