Concepts Behind Cash Flow From Operations Ratio
Cash Flow from operations is a ratio which is used to determine how well the company is using its cash flow generated from operations to cover for the current liabilities. Cash Flow from Operations ratio is calculated for the purpose of seeing how well the organization and management of the company's cash flows which are generated from operations is done.
All the company accounts use accrual basis rather than actual basis for preparation of their financial accounts. Due to this principle, sometimes a company account may show a fabricated picture of how the company is actually performing. It may show that the company has less current liabilities while in reality the current liabilities are huge. At times, the company may seem efficient in managing current liabilities in short term due to usage of the principle of accrual. However, it may not be true. This is why the use of Cash Flow from operations ratio is important.
Cash Flow from Operations Ratio or Operating Cash Flow Ratio shows the real picture of how well the company actually disposes off its current liabilities by using the cash which it generates as revenue.
The logic behind calculating this ratio is quite simple. A business earns revenue by selling well which are purchased from producers or suppliers. The goods are usually purchased in credit and thus, as a business earns revenue, it is important to keep paying off the suppliers or creditors. IT is also essential in order to obtain new stock. In case the organization or firm cannot pay its suppliers or creditors, it can either be due to the sales not going well. Now if the sales are going well and still the current liabilities are not being paid off, it shows a bad management or a non-optimal utilization of cash obtained from revenue which impacts the business and its reputation.
It is calculated as follows:
Cash Flow from Operations Ratio = Cash flow from Operations/Current liabilities
It is calculated in times.
Analysis of Cash Flow from Operations Ratio
A higher ratio implies that a company is able to cover for its current liabilities easily and many times during the year. It shows that a company can pay for its current credits multiple times a year.
In the contrary, a lower ratio would mean that the company is not efficient in paying off its liabilities and has a poor cash flow management system and needs to improve its cash management.
A company with a high Cash Flow from Operations ratio shows a good credibility from a company which makes more suppliers and creditors willing to lend goods on credit for the company while a low ratio would decrease the confidence of the suppliers and they might hesitate and refuse to give goods on credit to the business.
It is a simple computation of a company's liquidity and shows a better and more accurate picture of the company's position rather than the ratios which are calculated on accrual basis.
Difficulties Encountered In Cash Flow From Operations Ratio
A company's balance sheet might have some manipulations which are not allowed while calculating Cash Flow from operations. It becomes difficult to analyze the transactions and determine the exact cash flow from operations. This makes students spend a lot of time on reading the problem and being extra careful while selecting transactions which are to be taken into consideration for calculating Cash Flow from operations. This ratio involves computation of Cash Flow from operations as well as calculation of current liabilities in order to arrive to the actual Cash flow from operations formula.
The students have to take into consideration that the revenue and expenses may not go hand in hand while computing cash flow from operations for a period. This is a very different concept from the one used throughout the accounting problems. Thus, students often get confused and find it difficult to solve problems for this topic.
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