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.
Formula
The formula for this ratio can be easily judged by its name: Operating Cash Flow to Sales Ratio = Operating Cash Flow / Sales
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.
