Last Updated on November 22, 2022
A company’s cash flow margin is one measure of its profitability. The cash flow margin reveals whether an organization can convert sales activities into liquid assets. While this margin can also show how profitable a company is, there isn’t a firm, universal baseline.
A margin that’s ideal for one company might indicate a loss of profitability for another. What’s most important for organizations is to set profitability goals and KPIs. Then they can monitor and track changes in the cash flow margin over time.
What Is Cash Flow Margin?
A firm’s cash flow margin is also called its operating cash flow margin. This figure is one of the ratios organizations use to determine their ability to generate a profit. In this case, a firm is revealing how profitable its operating activities are. Operating activities include things that the company does to make and sell its products or services.
A company’s accounting department will also list operating activities on its statement of cash flows. Typically, firms generate cash in three ways: selling, financing, or investing. Cash flows from operating activities are usually considered to be the most important. It is vital because it indicates whether the firm has viable products and services and can generate more revenue from selling something than the expenses it incurs to get it to market.
How Cash Flow Margin Is Calculated
The different pieces that make up a company’s cash flow margin include:
- Net income
- Working capital
- Non-cash expenses, such as depreciation
The formula for operating cash flow margin is:
Cash Flow Margin = (Net Income + Non-Cash Expenses + Change in Working Capital) / Net Sales
Net income is revenue minus expenses, while sales represent gross revenues before expenses. Working capital is calculated by subtracting current liabilities from current assets. Non-cash expenses, including depreciation and amortization, can be calculated using various methods. The most common way companies figure out depreciation expenses is through the straight-line method.
Straight-line depreciation involves evenly dividing an asset’s projected loss of market value over that asset’s useful life. Let’s say the expected depreciation on a vehicle is $10,000, and its projected useful life is five years. A company will record $2,000 in depreciation expenses for that asset each of the five years.
The formula for calculating the cash flow margin itself is net income plus non-cash expenses plus the change in working capital divided by sales. A more straightforward calculation takes cash flows from operating activities divided by net sales.
Cash Flow Margin Calculation Example
Using the simpler of the two formulas, you can calculate the cash flow margin of a firm that generated $100,000 in cash flows from operating activities and $300,000 in net sales. Its cash flow margin is 33.34%.
Perhaps the same firm still generates $100,000 in cash flows from operating activities the following year, but its net sales decrease to $200,000. The company’s cash flow margin will increase to 50%, indicating an increase in profitability.
What Does Cash Flow Margin Analysis Tell You?
Cash flow margin analysis tells you whether a company’s business model is sustainable. If a company cannot produce enough profit from sales and operating activities, it is at risk of becoming insolvent. Generally speaking, the lower a company’s cash flow margin is, the less profitable it is.
If the firm’s cash flow margin continues to trend downward, it could indicate an impending or ongoing liquidity problem. This trend could also reveal a need to adjust the firm’s product/service strategy, marketing strategy, or cost management approach. However, a lower cash flow margin can also indicate a company is reinvesting its liquidity in the firm. Site expansions, acquisitions of smaller organizations, and capital expenses are typical examples.
So a year or two where the cash flow margin dips or remains stagnant isn’t necessarily a cause for concern. You need to take a deeper dive to determine what’s driving the changes in the percentage.
Limitations of Using the Cash Margin Formula
As the previous section alludes, you can’t rely on the cash margin formula alone to determine whether a company is doing well financially. The formula is only one measure of profitability and can be deceiving without a deeper analysis. Companies also use formulas like return on assets and return on equity to analyze profitability.
Startups and younger companies might also have lower or negative cash margins for the first few years. They need time to get established in the market and gain a solid customer base. Younger companies are more likely to have more cash flow from financing activities (e.g., loans, funds from investors) than operating activities.
Grey was previously the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helped businesses find the information they needed to make informed decisions about invoice factoring and A/R financing.