Cash Flow Return on Revenues
The term cash flow return on revenues refers to a metric that allows the investor-analyst to understand the ability of a company to generate cash at various revenue volumes. Cash flow return on revenues is not linear meaning it does not scale evenly.
Cash Flow Return on Revenues = (Net Income + Non-Cash Expenses – Non-Cash Revenues) / Revenues
- Net income is equal to sales revenues less all expenses, including depreciation, interest, and income taxes.
- Non-cash expenses include those accounting expenses in the current reporting period that are not associated with the payment of cash. The most common example of a non-cash expense is depreciation.
- Non-cash revenues include items appearing on the income statement that do not affect its cash flow such as investment gains.
Cash flow measures allow the investor-analyst to understand if the company is generating enough cash flow from ongoing operations to keep the company in a financially sound position over the long term. One of the ways to measure the ability of a company to generate enough cash from its core business operations is by calculating its cash flow return on revenue.
Also referred to as cash flow return on sales, cash flow return on revenues measures a company’s ability to generate cash at various levels of revenues. Typically, these costs occur stepwise. For example, if a company’s equipment is operating at its maximum capacity, it will need to increase costs significantly to increase sales since it will need to purchase new equipment to increase production.
While this measure can be used as a benchmark, the ratio will vary considerably by industry. A decision to invest in additional equipment to increase revenues may not achieve its desired cash flow results if additional market demand does not exist.
Company ABC’s Board of Directors believes it may be better to split the company’s electric distribution business from its generating unit operations. To gain additional insights into the performance of each business, the company’s CFO asks an analyst to determine the cash flow return on revenue for each business as shown below:
Line of Business Distribution Generation Revenues 3,200,000,000 2,500,000,000 Net Income 736,000,000 375,000,000 Add: Non-Cash Expenses 128,000,000 57,500,000 Minus: Non-Cash Revenues 38,400,000 37,500,000 Cash Flow Return on Revenues 28.2% 18.8%
The above table reveals both lines of business are producing reasonable levels of cash flow and each is worth keeping, with the distribution business outperforming its generating business.