Cash reinvestment ratio
/What is the Cash Reinvestment Ratio?
The cash reinvestment ratio is used to estimate the amount of cash flow that management reinvests in a business. It tends to be relatively steady over time, so a change in the ratio can signal that management has adopted a change in strategy that alters the amount of cash needed by a business.
Cash Reinvestment Ratio Analysis
A high cash reinvestment ratio might initially appear to indicate that management is committed to improving the business, but it could also mean that an excessive amount of investment in fixed assets and working capital is required to run the operation. Thus, the measure can be misleading, unless coupled with other metrics to obtain a more complete picture of company operations.
In particular, compare the company's ratio of fixed assets to revenues to those of well-run companies in the industry, as well as the ratio of working capital to revenues. If these ratios indicate better performance by the peer group, there is a strong likelihood that the subject company is investing more cash than necessary.
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Formula for the Cash Reinvestment Ratio
The formula for the cash reinvestment ratio requires you to summarize all cash flows for the period, deduct dividends paid, and divide the result into the incremental increase during the period in fixed assets and working capital. Additional points regarding the formula are:
Fixed asset sales. If any fixed assets are sold during the measurement period, factor out the impact of the sale.
Working capital elimination. A variation on the formula is to exclude working capital changes from the numerator. Doing so focuses attention solely on new fixed asset additions.
The formula for the cash reinvestment ratio is:
(Increase in fixed assets + Increase in working capital) ÷
(Net income + Noncash expenses – Noncash sales - Dividends)
= Cash reinvestment ratio
Example of the Cash Reinvestment Ratio
A prospective investor wants to calculate the rate of cash flow reinvestment for a possible investee. The investee is in a rapidly-expanding industry, so major reinvestment is normal. The ratio is:
(Increase in fixed assets + Increase in working capital) ÷
(Net income + Noncash expenses - Noncash sales - Dividends)
=
($350,000 + $550,000) ÷
($1,700,000 + $140,000 - $20,000 - $40,000)
=
$900,000 ÷ $1,780,000 = 51% Cash reinvestment ratio
Disadvantages of the cash Reinvestment Ratio
While the cash reinvestment ratio can provide useful insights, it also has several disadvantages, which are as follows:
Excludes financing activities. The ratio does not account for funds raised through external financing, such as debt or equity, which might significantly influence reinvestment decisions.
Limited insight into profitability. While the ratio highlights reinvestment of cash, it does not reflect the profitability of these reinvestments or the company's ability to generate returns on its investments.
Not applicable to some industries. In industries with low capital intensity or minimal reinvestment needs (e.g., service industries), the ratio may not provide meaningful insights.
Volatility. Cash flow from operations can fluctuate significantly due to seasonality or one-time events, making the ratio less reliable as a consistent performance measure.
Potential for misleading results. A high reinvestment ratio may seem positive but could indicate a lack of available cash for other priorities, such as debt repayment or dividend payouts. Conversely, a low ratio might suggest poor reinvestment but could reflect prudent cash management
While the cash reinvestment ratio is a useful tool for assessing how much of a company's operating cash flow is reinvested, its disadvantages make it necessary to use it alongside other financial metrics and a broader understanding of the company's financial health.
Terms Similar to Cash Reinvestment Ratio
The cash reinvestment ratio is also known as the cash flow reinvestment ratio.