Operating Cash Flow to Sales Ratio – Formula, Assumptions and Interpretation

Formula

The formula for this ratio can be easily judged by its name:

Operating Cash Flow to Sales Ratio = Operating Cash Flow / Sales

Meaning

• 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.

Assumptions

• 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.

Interpretation

• 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.