What is the role of Debt to Cash Flow ratio in stock market investing?
What do you do in business? You simply buy or manufacture certain products and then sell them at a price higher than the bought or cost price and that way you make a profit (after deducting all the expenses and taxes).
Suppose it cost you net INR 20 (Rs.20) per item you manufacture and say you sold 1000 pieces of it at a price of INR 25 (Rs.25) per piece. So the profit made by you after selling 1000 pieces will be INR 5000 (Rs.5000) (25000 - 20000). This is simple mathematics that everyone knows. You sold the 1000 pieces and let us assume that the items were also delivered to the party who bought from you.
But the party says that they will complete only 80% of the payment for this deal in the current month and rest will be paid in the first week of the next month. In other words, they will pay INR 20,000 (Rs.20,000) in the current month (as 80% of INR 25,000 is INR 20,000) and rest of the amount of INR 5000 (Rs.5000) will be paid in the first week of the next month.
Now if we make a profit and loss account and balance sheet of the current month (when items were sold) it will show a gross profit of INR 5000 (Rs.5000) but the actual cash of INR 5000 (which is also the gross profit) will still be not with you (or your company) as the buyer will complete the remaining 20% payment (INR 5000) next month. So we can say that the net operating cash flow is zero at the end of the month by the below formula.
Net Operating Cash Flow = Cash Receipts - Cash Payments (during a period of time- end of the month here)
20,000 – 20,000 = 0
If the company receives the INR 5000 the next month then the next month the operating cash flow will not be zero and it will be INR 5000 + operating cash flow of the next month as well (if any).
That is the major difference between the operating cash flow and profit where operating cash flow is the actual net amount received as cash (money) (it may also be in the form of digital money or cheque and not necessarily only paper currency) while the calculated profit is just to show in books though both are actual profits.
So if you want to understand the meaning of cash flow it is the actual net cash (money) that is received in the company rather than something that is just in books or the balance sheet.
Net Operating Cash Flow = Cash Receipts - Cash Payments (during a period of time) from the core business of the company only.
Cash flow may be generated by a company in three different ways. The operating cash flow is the one that is generated from its core business while other two types of cash flow are the cash generated from investing activities and financing activities.
Net cash flow = Cash Flows from Operating Activities + Cash Flows from Investing Activities + Cash Flows from Financing Activities.
Most important is the cash flows from the operating activities which are the net cash flow (cash receipts - cash payments) in the actual business the company does. Suppose a company is in the manufacturing business and paid to its raw material suppliers and employees cash of INR 5,00,000 (Rs.5 lac) during a given period of time (say 1 year). In the same period suppose the company also received money (cash) of INR 6,00,000 from its customers by selling goods of worth INR 5,00,000 (after adding their profits to it).
Since buying (for manufacturing) and selling is the core business of the company so the net cash flow of INR 1,00,000 (Rs.1 Lac) (6 lac – 5 lac) during that given period of time will be the operating cash flow of the company. Here the cash flow is positive as the cash generated by selling (to customers) is more than the cash utilized to pay for manufacturing (and to employees) which is a good sign that shows company’s profitability.
Operating cash flow may also be negative if a company is selling its products with a loss or it may be that the payments due for receipt by the customers still not cleared by them at the end of the year (closing period). This usually happens when the company sells its goods or products on credit and so there is no instant payment by the customers.
You don’t really need to calculate net operating cash flow manually. Just make use of the search box above on this site to look for the financial data of any Indian stock listed company for past 10 years and among it, you can also find the net operating cash flow of the company for different years.
A positive (great than zero) and increasing net operating cash flow on YOY (year to year) basis is a good sign of company’s growth in terms of profits. But the net operating cash flow may not be increasing and vary (uneven) on the YOY basis if the company is selling its goods or products on credit.
But the operating cash flow may even go down on the YOY basis if the company is paying its debt from the net operating cash flow or if the company is making a loss in the business.
Now let us see how ‘debt to cash flow from operations’ ratio can be utilized in stock market investing.
Debt to cash flow from business operations is nothing but the debt divided by the operating cash flow at the end of a financial year. Suppose the debt in the books of a company as on 31st March 2017 is INR 3cr while the operating cash flow is INR 0.5 cr.
If the company uses all this cash (0.5 cr) to repay its debt in the current year then total it will take 6 years (3cr/0.5cr=6) for the company to repay its total debt of 3cr provided the same cash of INR 0.5 cr is generated by the company every year. While in reality, this is not possible to generate the same cash every year (as sales may vary every year) but this gives a lump sum idea about company’s debt situation.
Usually, there is nothing to worry about as long as the debt to cash flow from operations is less than 1. If the operating cash flow is negative then this ratio will also be negative which is not a good thing but for some companies, this may be a temporary problem as they might be selling their goods on credit and so their payments were stuck with the customers temporarily.
Written By:Rajesh Bihani, senior writer at sharemarkethow.com