This is an ultimate guide on how to calculate Cash Reinvestment Ratio with detailed interpretation, analysis, and example. You will learn how to use its formula to perform a company’s valuation.
Definition - What is Cash Reinvestment Ratio?
The cash reinvestment ratio, also known as the cash flow reinvestment ratio, is a useful metric that measures the percentage of annual cash flow that a company is investing back into its business.
Investors are keen to watch the fluctuations of a company’s cash reinvestment rate, because it can be indicative of its long-term goals and strategies.
The conventional way of thinking is that a high cash reinvestment ratio signifies a company that is expecting significant growth (think young tech companies).
On the other hand, a low cash flow reinvestment rate signifies a mature, stable company that does not expect rapid growth or expansion (think large manufacturing companies).
The equation for the cash reinvestment ratio is as follows:
Cash Reinvestment Ratio = (Increase in Fixed Assets + Increase in Working Capital) / (Net Income + Noncash Expenses - Noncash Sales - Dividends)
To compute the ratio, you add the incremental increase in fixed assets to the increase in working capital, and divide the result by the net income, plus noncash expense, minus non-cash Sales and dividends.
You can easily this information on a company’s balance sheet and income statement.
Okay now let’s consider an example so you can see how easy it is to calculate this ratio.
Suppose between 2016 and 2017, a company increased its fixed assets and working capital $80 million and 20$, respectively.
Additionally, in that time span, the company reported net income of $100 million, non-cash expenses of $50 million, non-cash sales of $10 million and $20 million in dividends.
By plugging the numbers into the equation, cash reinvestment ratio is calculated to be 83%.
Meaning that 83% of the company’s available cash flow is being reinvested into the company’s operations.
Interpretation & Analysis
In the example above, 83% cash flow reinvestment ratio may seem appealing to an investor because it may indicate that a company is entirely committed to itself and its operations, and therefore may be poised for major growth in the upcoming years.
It makes sense intuitively: if a company is investing a considerable majority of its available cash in its business operations, it is not foolish to assume that the investment will produce immense returns as the company continues to grow from those investments.
Cautions & Further Explanation
While a high cash reinvestment rate may be an attractive sign for some investors, it has its limitations.
It’s true that, most of the time, young, poised-for-growth companies have a high (if not 100%) cash flow reinvestment ratio.
However, companies that are poorly managed and run incredibly inefficiently may also have high cash reinvestment ratios.
For example, a company could be spending 90% of its cash flow on its assets and working capital, but if management properly updated the machinery, and negotiated better contracts with their suppliers, they would be able to get that number down to 60%.
This is a prime example of a company with a high cash flow reinvestment rate that is not only not primed for high growth, but is mismanaged and likely to not succeed in the long term.
Therefore, before making any investment decisions, it is imperative to calculate other ratios and peruse the company’s financial statements to become better informed of the company’s financial health and long-term goals.