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What is the Operating Cash Flow Margin?

Operating cash flow margin is a cash flow ratio which measures cash from operating activities as a percentage of sales revenue in a given period. Like operating margin, it is a trusted metric of a company’s profitability and efficiency and its earnings quality.

The cash flow margin is one of the more important profitability ratios for a company / firm. It tells how well the company / firm converts sales to cash—and cash is of critical importance because it’s required to pay expenses. The conversion of sales to cash is vital.

Profitability ratios show a firm’s overall efficiency and performance. These ratios can be divided into two types: Margins & Returns

Ratios that show Returns represent the firm’s ability to measure the overall efficiency of the firm in generating returns for its shareholders / Business Owner.

Levered free cash flow is the “free” cash flow that’s left after a business has met its financial obligations on any outstanding accrued debt. The levered cash flow is the amount of cash left over for stockholders after all financial obligations are met.

Levered Free Cash = Cash flows – Debt Obligation (Interest Payments / EMI Payment)

How Is Cash Flow Margin Calculated?

The cash flow margin is a measure of how efficiently a company converts its sales to cash. Because expenses and purchases of assets are paid from cash, this is an extremely useful and important profitability ratio. It’s also a margin ratio.

The cash flow margin is calculated for a given Month / Quarter / Year as:
Cash flows from operating activities (A) / Net Sales (B) = _______ percent
Where (A) is the free cash flow from operations and is calculated by deducting all expenses for the given term from net sales.

Working Example:

Assuming company ABC recorded the following information for 2018 business activities:
Sales = Rs. 5,000,000
Depreciation = Rs. 100,000
Working Capital = Rs. 1,000,000
Net Income = Rs. 2,000,000
And recorded the following information for 2019’s business activities:
Sales = Rs. 5,300,000
Depreciation = Rs. 110,000
Working Capital = Rs. 1,300,000
Net Income = Rs. 2,100,000
We calculate the cash flow from operating activities for the 2019 as:
Cash Flow From Operating Activities = Rs. 2,100,000 + (Rs. 110,000) + (Rs. 1,300,000 – Rs. 1,000,000) = Rs. 2,510,000
To arrive at the operating cash flow margin, this number is divided by sales: Operating Cash Flow Margin = Rs. 2,510,000 / Rs. 5,300,000 = 47.35%

Company Use

Cash flows from operating activities, which is the numerator (A), come from the statement of cash flows. Net sales come from the company’s income statement.
If a company is generating negative cash flow, this would show up as a negative number in the numerator in the cash flow margin equation. Therefore, the company is losing money even as it is generating sales revenue. It would have to borrow money or raise money through investors to continue operating.
But there’s a flip side. Generating negative cash flow for a limited period of time can have long-term beneficial results depending on where the cash is flowing. If it’s going toward expansion, this could be expected to not only balance cash flow again when the project is completed but increase it into a far more positive and profitable range.

What Is the Net Profit Margin Ratio?

The net profit margin ratio is a profitability ratio that is a margin ratio. It can be calculated by using numbers from the company’s income statement. The net profit margin is the number of rupees of after-tax profit a firm generates for each rupee of sales.
For example, if a firm generates Rs. 1,000.00/- of sales revenue and has a 5 percent net profit margin, this means it generated Rs. 50.00/- of profit.
It’s calculated as:

Net Income/Net Sales = ________ percent

Net sales are simply sales revenue with any returns and allowances subtracted out. Net income is income with all expenses subtracted out, including taxes, interest expenses, and depreciation. It is the “Bottom line.”

Meanwhile, the net profit margin indicates how well the company converts sales into profits after all expenses are subtracted out. Because industries are so different, the net profit margin is not very good at comparing companies in different industries.

Key Takeaways:

  • Keep in mind that this is not the same as the Net Income Margin, which includes non-cash transactions such as bad debt expenses and depreciation.
  • Cash Flow Margins although higher is better.
  • There is no “perfect” percentage to aim for because all companies are different.
  • A firm that shows an increasing cash flow margin from year-to-year is certainly getting stronger with time, and this is a good indicator of its probability for long-term success.
  • This is an important indicator for a banker / lender to arrive at the viability of the firm they are funding (may not be true for start – ups).
  • Negative cash flow may not mean losing money if the same is invested in new project / expansion.
  • Working Capital can be added through short term debt to capitalise on opportunities in business and is better than raising equity (helps in maintaining the cash flow margin without altering it)
  • Profit margins helps firms to calculate its profitability and bottom line.

Actionable Task:
1. Start calculating Operating Cash Flow Margins in Monthly / Quarterly / Yearly basis, this help you to keep track of the health of your business. Remember what gets measured, gets done.

2. You may take help of your auditor or financial planner to develop a simple excel sheet, where you can enter data on a monthly basis based on your current and previous year balance sheets.

3. It is advisable to calculate your bottom line on a quarterly and half yearly basis to take required course correction to achieve your financial goals for the year.

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