What is cash flow to sales ratio?

What is cash flow to sales and why is it important?

The cash flow to sales ratio, operating cash flow to sales ratio, or OCF/sales ratio, measures a business’s current cash flow after subtracting all capital expenses related to sales costs. In essence, it analyzes operating cash flow against current sales revenue.

The cash flow to sales ratio provides valuable insights into a company’s ability to generate cash flow relative to its sales volume. It is calculated by dividing operating cash flows by net sales. Operating cash flows can be obtained from a company’s statement of cash flows, while net sales are typically found near the top of its income statement.

Ideally, the ratio should remain relatively stable as sales increase. However, a declining ratio may indicate various underlying problems within the business:

1. Decrease in cash generation. If the ratio declines, it may suggest that the business generates less cash relative to its sales volume. This could be due to various factors such as increased expenses, inefficient operations, or pricing strategies that yield lower margins.
2. Extended payment terms. A declining ratio could also indicate that the business is offering longer payment terms to its customers, resulting in cash being tied up in accounts receivable. While extending credit terms may stimulate sales growth, it can adversely impact cash flow if collections are delayed.
3. Increased overhead costs. As sales volume grows, businesses may need additional infrastructure, resources, or overhead expenses to support operations. If these investments outpace the growth in cash flow, it can lead to a decline in the cash flow to sales ratio.

A declining cash flow to sales ratio may signal underlying challenges that need to be addressed, such as inefficiencies in operations, cash flow management issues, or pricing and credit policies that are not conducive to maintaining healthy cash flows. Therefore, monitoring this ratio is essential for businesses to identify potential areas for improvement and ensure sustainable financial performance.

How to calculate cash flow to sales ratio

To calculate the cash flow to sales ratio you only need two metrics:

• Net sales. It’s what remains after all returns, allowances and sales discounts have been subtracted from gross sales. You can find this figure in your company’s income statement.
• Operating cash flow. Operating cash flow shows how much money a business earns from typical operations, and it’s calculated as revenue minus operating expenses. You can find this figure in the cash flow statement.

Once you have calculated or located these two metrics, you can calculate your cash flow to sales ratio by following this formula:

Cash flow to sales ratio = operating cash flow / net sales

By calculating the cash flow to sales ratio using this formula, you can assess your business’s ability to generate cash and make informed decisions for improvements.

Interpreting your cash flow to sales ratio results

Maintaining a healthy cash flow is crucial for the sustainability and growth of any business. With adequate cash reserves, a business can not only expand but also reinvest in core operations. Also, a higher cash flow to sales ratio can enhance the business’s attractiveness to potential investors and lead to more favorable credit terms from financial institutions.

In broad terms, an operating cash flow to sales ratio falling within the range of 10% to 55% is typically considered favorable, with a higher percentage indicating a stronger ability to convert sales into cash. However, the true value of analyzing this ratio lies in comparing it to industry benchmarks. By benchmarking against similar businesses, you can gain valuable insights into your company’s performance relative to peers and identify areas for improvement.

Summary

• The cash flow to sales ratio assesses a company’s ability to convert sales revenue into cash effectively.
• It measures the proportion of operating cash flow to total sales revenue, providing insights into liquidity, operational efficiency, and financial health.
• Calculation formula: Cash flow to sales ratio = Operating cash flow / Net sales.
• A declining ratio may indicate problems such as decreased cash generation, extended payment terms to customers, or increased overhead costs. Monitoring this ratio is crucial for identifying areas of improvement and ensuring sustainable financial performance.

Sources:

• planergy.com
• www.accountingtools.com
• altline.sobanco.com
• www.investopedia.com