Friday, October 16, 2009

Measuring Investment Capacity: Operating Cash Flow to Capital Expenditures

The price that an investor is willing to pay to acquire a share of a corporation's common equity is largely a function of the corporation's potential earnings growth. When purchasing a stock, you are effectively paying for earnings growth in advance of its actual occurrence. At a basic level, in order to grow, a company must be able to invest in both its existing and future property, plant and equipment. A grading contractor who can barely afford the maintenance on his existing machinery will most likely not be expanding the business any time soon. Therein lies the analytical significance of the Operating Cash Flow (OCF) to Capital Expenditures (Capex) Ratio.

Once again, net cash flows provided by operating activities serves as the foundation of this ratio; because non-cash items on the income statement won't exactly help a company purchase a new tract of land or an excavator, we can go ahead an dismiss net income as irrelevant. The point is to isolate the cash generated by a company's operations, and determine whether it is adequate to fund investment in its income producing assets. To calculate the ratio, simply go to the statement of cash flows, and divide "Cash flow from operations" by "Capital Expenditures". A ratio greater than one (1) indicates that a company's operations are generating the cash necessary to fund its annual investment needs. I'll use the cash flow rich Exxon (XOM) as an example:

Operating Cash Flow to Capital Expenditures = Operating Cash Flow / Capital Expenditures
= $59,725M / $19,318M
= 3.09

During fiscal year 2008, Exxon generated over three times the cash needed from operations in order to fund investment in its plant, property and equipment. The chart below compares the ratio for several other companies.

Clearly, some companies are more cash rich than others, and are better prepared to fund growth internally. A ratio of less than one (1) is indicative of a company that may need to borrow money, or that is in decline. I think we all know the story of Blockbuster (BBI); its ratio is so low because it is in decline (to be fair, it is officially in decline from a brick and mortar video delivery standpoint). OCF to Capex is definitely an important ratio that should be part of every investors toolbox. Sphere: Related Content

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