The cash reinvestment ratio, also known as the cash flow reinvestment ratio, is a valuation ratio used to measure the percentage of annual cash flow that the company invests back into the business as a new investment. This ratio allows analysts to understand the degree to which net income is put back into the business. Investors usually track this ratio to observe fluctuations in a company’s cash reinvestment rate. It can be indicative of its long-term goals and strategies.
When more cash is put back in the business, it can show that the company is expecting significant growth in its operations. This is usually typical for young companies. On the other hand, a low cash reinvestment is a sign of maturity, stability in a company that is not expecting rapid growth or expansion, and this is always common in large and well-established companies.
A consistently high or increasing cash reinvestment ratio is desired as it means that the business has unexploited potentials, and it is committed to growth in the future. To gain a more realistic picture of how the company is performing, its cash reinvestment ratio can be compared against its peer group in the same industry.
Cash Reinvestment Ratio Formula
All the information required in calculating the cash reinvestment ratio is available on the company’s balance sheet and income statement. Be aware that the cash flow amount should be adjusted for dividends. Companies using this ratio should factor out the impact of the sale of any fixed assets sold during the measurement period.
You can calculate cash flow adjusted for dividends by adding up non-cash expenses, such as depreciation and amortization, and the net income of the company. Then subtract non-cash sales and dividends:
Companies using this ratio must pay attention to two situations in particular. The first involves fixed asset sales, while the second involves working capital elimination.
- If any fixed assets are sold during the measurement period, you need to factor out the impact of the sale.
- A variation on the formula excludes working capital changes from the equation. Doing so focuses your attention solely on new fixed asset additions.
To gain a more realistic picture of how the company is performing, this ratio can be compared against its other companies within the same industry. Usually, a higher ratio is preferred as it indicates a strong likelihood of significant growth in future.
Cash Reinvestment Ratio Example
Donald, an investor, is considering purchasing shares from FGT Company in New York. As an experienced investor, he first decided to find out if the company is committed to growth. Donald requested the company’s most recent balance sheet and income statement. He extracted the information below. Find their cash reinvestment ratio so he can make a final decision.
- Fixed asset increase of $5,054,000
- Working capital increase of $4,500,000
- Net income of $6,023,000
- Non-cash expenses of $168,000
- Non-cash sales worth $30,000
- Paid dividends of $50,000
Now let’s break it down and identify the values of different relevant variables in the problem. To calculate the adjusted cash flow, we can add non-cash expenses ($168,000) and the net income ($6,023,000). Then subtract non-cash sales ($30,000) and dividends ($50,000).
- Adjusted cash flow: $6,111,000
- Increase in Fixed assets: $5,054,000
- Increase in Working Capital: $4,500,000
We can now apply these variables to the formula:
For this equation, the cash reinvestment ratio is 1.56. Since it is more than 1.0, this indicates that the company has growth potential. It can reinvest cash into the business and still have some money to fund its growth. Donald might assume the company is worth investing in, but he should evaluate other financial metrics before purchasing shares of stock.
Cash Reinvestment Ratio Analysis
Cash reinvestment ratio measures the percentage of the company’s annual cash flow that’s reinvested back into the business. Investors study this ratio keenly to find out if there are any fluctuations in the reinvestment rate. It can enable them to understand the strategy the company is using now to sustain its long-term goals.
Generally speaking, a high ratio can look appealing to investors. It implies that the company has potential for significant growth and expansion of its operations in the upcoming years whereas, a low ratio, commonly found in already established companies signifies stability in its operations such that they have all that is needed to turn over its investors’ cash to earn them income.
However, a high ratio might also mean that funds are poorly managed. For instance, a company could be spending almost all its cash on increasing fixed assets and working capital. But if the management were to properly update machinery or renegotiate supplier contracts, they would be able to bring that number down.
Also, a high ratio might be due to excessive investment in fixed assets and working capital. These don’t generate income for the company. Since reinvested cash acts as a new investment, there’s a high probably that this company can’t source income from somewhere. Investors might be afraid to invest, so it recycles its own funds. So use caution as you calculate this ratio. Check the company’s financial statements before making any investment decisions. This will keep you more informed of the company’s financial health and long-term goals.
Cash Reinvestment Ratio Conclusion
- Cash reinvestment ratio is a valuation metric that measures the percentage of annual cash flow that is the company invests back into the business.
- A high ratio implies that the company has the potential for significant growth and expansion in the future, signalling efficient operations
- A low ratio suggests that the company is stable in its activities and probably has grown to its full capacity.
- The cash reinvestment ratio requires up to six variables: increase in fixed assets, increase in working capital, net income, non-cash expenses, non-cash sales, and dividends.
Cash Reinvestment Ratio Calculator
You can use the cash flow reinvestment ratio calculator below to quickly calculate the percentage of the company’s annual cash flow that is reinvested back into the business by entering the required numbers.
FAQs
1. What is the cash flow reinvestment ratio?
The cash flow reinvestment ratio is an indication of how much cash a business has available to reinvest in its operations or other investments. The higher the cash flow, the more that can be reinvested.
2. What is cash reinvestment?
Cash reinvestment is a term used to describe the change in retained earnings over a certain period of time. It can be calculated using the following formula:
cash flow from operations - dividends = net income + depreciation - increase in working capital - decrease in fixed assets.
3. What does the reinvestment rate mean?
The reinvestment rate is simply the percentage of available cash flow that is reinvested back into the business. The higher the reinvestment rate, the more cash flow available to be put back in. If there are no further effects on this ratio, then it will result in an increase in EPS over time.
4. Why is cash reinvestment important?
Cash Reinvestment is important because it allows a business to expand.
5. How does cash reinvestment make money?
Reinvestment is what allows a company to grow. The profits not paid out as dividends are available for reinvestment, which leads to the business earning even more money.
