Cash flow is the money flowing in and out of a company. It keeps your business going, and its ratio says a lot about your financial health.

But what is a healthy cash flow ratio, and how can you work it out?

This guide will cover:

  • Importance of the cash flow statement
  • Ratios to look at when analysing cash flow performance
  • Signs of a healthy cash flow ratio

Whether you’re a small business owner or a sole trader, Countingup can help you understand and manage your finances efficiently and effectively.

If you need to brush up on what cash flow is, we have a separate guide for you to read here

Importance of the cash flow statement

A typical cash flow statement reports the details of when (and from where) your company has received income and paid expenses during a specific period. Cash flow statements break down the company’s cash flow into three categories: operating cash flows, financing cash flows, and investing cash flows

  • Operating cash flows refer to the money your business makes and spends running your daily operations. 
  • Financial cash flows come from funds relating to any financial backup your business needs, such as debts, equity, or paying dividends. 
  • Investing cash flows includes money you spend and receive from buying or selling investments like property, stock, or equipment.

Your cash flow statement shows your income and expenses over a specific time, usually a month, quarter or financial year. These statements also include any deferred taxes and basic operational fees.

The cash flow statement is crucial to running a business as it gives you and potential investors insight into how your business is performing financially. 

Ratios to look at when analysing cash flow performance

Below we’ve listed the main ratios to take into account when analysing your overall cash flow health. 

Operating cash flow ratio

This ratio shows the amount of cash generated by your company’s basic business operations and shows your company’s overall health. You use the operating cash flow ratio to determine if the business can meet its short-term debt liabilities. However, this ratio doesn’t include any dividends (profit shares) you distribute to shareholders. 

Use the formula below to calculate your company’s operating cash flow ratio:

Operating cash flow = Net cash from operations ÷ Current liabilities

Ideally, your operating cash flow ratio should be fairly close to 1.1, meaning you make 10p per £1 you make. A ratio smaller than 1.0 means that your business spends more than it makes from operations. The higher the number is, the more your business is making.

Current liability coverage

Current liability coverage determines if your company can generate cash that you can use to cover debts that need paying within one year. This ratio also considers the value of your dividends. 

Use the formula below to calculate your company’s current liability coverage. Same as with operational cash flow, if this ratio is less than 1.0, it means your business suffers a liquidity crisis and is in danger of failing to meet its financial obligations.

Current liability coverage = (Net cash from operations – dividends) ÷ Average current liabilities.

Cash flow coverage ratio

This ratio determines whether your company can meet its obligations to pay back its total debt. Unlike the current liability coverage ratio, the cash flow coverage ratio considers debts with a maturity of more than one year. 

In other words, this ratio determines if you’ll be able to pay off all your debts on time. Like the current liability coverage, if the number is below 1.0, the company is in danger of default.

Cash flow coverage ratio = net cash flow from operations ÷ total liabilities.

When doing the calculations for these ratios, remember that you want the final number to be as high as possible. A high number means your business has a good financial position. 

How do I know if my cash flow ratio is healthy?

There are a few ways you can see if your cash flow ratio, and therefore your overall financial performance, is positive or negative. We’ve listed a few signs of a healthy cash flow below:

Steady growth in cash flow

Suppose you see a steady increase in the amount of cash flowing in and out of your business. In this case, it generally means your business is growing. A continued cash flow growth could be a sign that you have found a way to generate reliable revenue (gross income from sales) to a growing customer base. 

However, this isn’t always the case. If your company experienced a spike in cash flow because of a seasonal event like Christmas, then the growth isn’t necessarily proof of a healthy cash flow. 

Higher cash flow than net income

Another way to measure your company’s cash flow health is to compare your net operating cash flow to your net income. Your net income is the money you make after paying off all your financial obligations like taxes.

If your operating cash flow numbers are higher than your net income, it’s a sign that your business is doing well. Ideally, you should aim to consistently keep your net operating cash higher than your net income.

Healthy inventory turnover

Think about your inventory as frozen cash. It’s there, but you can’t reach it without breaking the ice, i.e. selling your products. Take a look at your inventory-to-sales ratio to determine if you sell as many products as you stock up on. 

If you notice a trend of your inventory outweighing your sales, try buying less of the products that don’t perform as well. Instead, consider stocking your inventory with products you know will sell to improve this ratio. 

Balanced financing ratio

If you frequently find yourself turning to new debt or equity for cash, it could be a sign that your business doesn’t generate enough earnings. While it’s perfectly fine to get some financial backing from business loans, a healthy cash flow ratio should be relatively low on financing cash. 

In the simplest terms, a healthy cash flow ratio occurs when you make more money than you spend. While measuring your cash flow isn’t as simple in practice, this guide should help you analyse your cash flow ratio better.

It may seem daunting, but keeping track of your cash flow can be manageable with the right tools. That’s why the Countingup business current account comes with free built-in accounting software to help you understand and manage your business finances.

Keep track of your cash flow with Countingup

Countingup is the two in one business current account and accounting app that provides real-time insights into your cash flow so that you can keep your business running like clockwork.

Find out more here.