Calculating Cash Flow Margin

A company's cash flow margin is critical

Businessperson working on calculating their cash flow margin at a desk surrounded by calculator, iPad, and computer.

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

Profitability ratios show a company's overall efficiency and performance. These ratios can be divided into two types: margins and returns.

Ratios that show margins represent the firm's ability to translate sales dollars into profits at various stages of measurement. Ratios that show returns represent the firm's ability to measure the overall efficiency of the firm in generating returns for its shareholders.

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

How Is Cash Flow Margin Calculated?

The cash flow margin is a measure of how efficiently a company converts its sales dollars 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 as:

Cash flows from operating activities/net sales = _______ percent 

The higher the percentage, the more cash is available from sales. If cash flows were $500,000 divided by net sales of $800,000, this would work out to 62.5 percent—very good, indicating strong profitability. It would drop to a 55.5 percent cash margin with an additional $100,000 in net sales. 

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. And although higher is better, there is no "perfect" percentage to aim for because all companies are different. But a company 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. 

Company Use

Cash flows from operating activities, which is the numerator, 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. 

Investor Use

Cash flow margin can be a shifty number for investors to rely upon because companies can voluntarily adjust cash flows from operation, and they might want to do so periodically for a number of reasons. They might temporarily hold off on paying accounts payable and other expenses, thus retaining more cash.

The cash flow margin calculation is most often advantageous for the company itself as more or less of a barometer as to how it's performing. If you want to use it to gauge investing opportunities, consider looking at different cash flow margins for the company at incremental periods of time to ascertain consistency. You want a panoramic view, not a single snapshot.

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 dollars of after-tax profit a firm generates for each dollar of sales.

For example, if a firm generates $1 of sales revenue and has a 5 percent net profit margin, this means it generated 5 cents 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.

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