What it means
The ratio takes operating cash flow from the top section of the cash flow statement and divides it by capital expenditure from the investing section. Both figures are already reported, so no adjustments or estimates are needed.
Its value lies in answering a question that profit figures cannot: is this company paying for its own future? A business that consistently generates two or three times the cash it needs to reinvest has genuine freedom to pay dividends, repay debt or make acquisitions.
The ratio is highly industry-specific. A software firm may score above ten because it barely buys equipment, while an airline or utility renewing its asset base may sit below one for years without anything being wrong, so comparisons only make sense within a sector.
A useful refinement is to split capital expenditure into maintenance spending, which keeps existing assets working, and growth spending on new capacity. A company below 1.0 overall but comfortably above 1.0 on maintenance capital expenditure is investing for growth rather than struggling to stand still.
The nuance to watch is timing. Capital projects are lumpy, so a single year can look alarming or flattering, and a three to five year average is far more revealing than any one reporting period.
Lenders use the ratio as a warning light rather than a covenant. A company whose ratio has slipped below 1.0 for three consecutive years is either investing heavily for growth, which should eventually show up in revenue, or quietly funding routine replacement with borrowed money, which is a far less comfortable position.
In practice
Real-world examples.
Example
A regional airline generates operating cash flow of $60,000,000 while spending $75,000,000 on aircraft deliveries, giving a ratio of 0.8. The shortfall is funded with aircraft financing, which the market accepts as normal for the sector.
Example
A business software company produces operating cash flow of $22,000,000 and spends only $2,000,000 on laptops and data centre equipment, for a ratio of 11.0. Its board directs the surplus into a share buyback rather than letting cash accumulate. The auditors note that most of the firm's real investment is engineering salaries, which are expensed rather than capitalised, so the ratio overstates how little the company reinvests.
Example
A grocery chain reports operating cash flow of $140,000,000 against total capital expenditure of $100,000,000, a ratio of 1.4. Splitting out $60,000,000 of maintenance spending gives a maintenance ratio of about 2.3, showing the pressure comes from new store openings rather than the existing estate.
Formula
Calculation
CF to CAPEX = Operating cash flow / Capital expenditure.
A regional bottling company reports operating cash flow of $18,000,000 for the year. It spent $7,500,000 on a new filling line, warehouse racking and delivery vehicles.
CF to CAPEX = $18,000,000 / $7,500,000 = 2.4 times.
The company generated 2.4 dollars of operating cash for every dollar it invested, leaving a surplus of $18,000,000 - $7,500,000 = $10,500,000 to service debt, pay dividends or build cash reserves. If capital spending rose to $18,000,000 in the following year, the ratio would fall to exactly 1.0 and every dollar of operating cash would be consumed by investment.Case study
Seen in the real world.
Fenwick Paper Mills is an illustrative and entirely invented manufacturer used to show how quickly this ratio can turn. In its strong years it generated operating cash flow of $30,000,000 against capital expenditure of $12,000,000, a ratio of 2.5, and the board grew comfortable approving new projects without much debate.
Then demand softened and two machines needed rebuilding in the same year. Operating cash flow fell to $14,000,000 while capital expenditure rose to $20,000,000, dropping the ratio to 0.7 and forcing the company to draw $6,000,000 from its revolving credit facility.
In this fictional case the finance director introduced a rule that maintenance and growth capital expenditure would be budgeted separately, with growth projects approved only when trailing operating cash flow covered maintenance spending at least twice over.
Watch out
Common mistakes.
- Judging a company on a single year's ratio. Capital projects arrive in lumps, so one heavy investment year can make a healthy business look stretched.
- Comparing the ratio across industries. A ratio of 0.9 is unremarkable for a utility and alarming for an advertising agency.
- Forgetting that acquisitions are not capital expenditure. Money spent buying other companies sits elsewhere in the investing section and is excluded from this ratio.
Questions
People also ask.
Is a very high ratio always good?
Not necessarily; a persistently high figure can mean the company is underinvesting and quietly letting its asset base age.
Where do the two numbers come from?
Operating cash flow is the subtotal of the operating section of the cash flow statement, and capital expenditure is usually shown as purchases of property, plant and equipment in the investing section.
How does it relate to free cash flow?
Free cash flow is the difference between the two figures, while this ratio expresses the same relationship as a multiple, which makes companies of different sizes easier to compare.
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