Cash Reinvestment Ratio is useful for determining the amount of cash flow that a company is routinely plowing back into the business. This can be indicative of a strong commitment by the owners to build the business. However, it can also mean that a company is being so poorly run that it requires an excessive amount of working capital and fixed assets to stay in business. This post provides cash investment ratio formula and calculation example that you can implement to analyze any real business.

Advertisement

 

Cash Reinvestment Ratio Formula

To calculate the ratio, summarize cash flow for the period, subtract any dividends paid, and then divide the result by the combined incremental increase in both fixed assets and working capital. When determining the incremental increase in fixed assets, be sure to factor out the net impact of any fixed asset sales during the period—otherwise, the incremental increase in assets due to the acquisition of assets will appear to be deflated. An alternative calculation is to eliminate changes in working capital from the numerator, which allows one to focus on the key investments being made in a company’s plant and equipment.

The formula is:

Increase in fixed assets + Increase in working capital
————————————————————————————–
Net income + Non cash expenses – Non cash sales – Dividends

 

Cash Reinvestment Ratio Calculation Example

An investor wants to determine the amount of cash flow reinvestment for a target company. It is in a growth industry, and a high rate of reinvestment is expected. The ratio is:

Increase in fixed assets + Increase in working capital
——————————————————————————————– =
Net income + Non cash expenses – Noncash sales – Dividends

$250,000 + $450,000
————————————————————–
$1,200,000 + $125,000 – $28,000 – $50,000

$700,000
————— = 56%
$1,247,000

 

From the investor’s perspective, the target company does not appear to be investing a sufficient quantity of its cash flow back into the business; in a high growth situation, a company should not only be reinvesting 100% of its cash flow, but also scrambling to line up additional funding for yet more reinvestment. The investor should closely question the management team regarding their perceived slow rate of internal asset growth.

As noted in the description, Cash Reinvestment Ratio can be an indicator of a continuing commitment to a business or mismanagement that requires the continual addition of assets to stay in business. To see if the underlying issue is related to mismanagement, calculate the ratio of fixed assets to revenue, and see how this correlates to the same ratio for other businesses in the same industry. The ratio of working capital to sales can be used in the same fashion. If these ratios indicate unusually high proportions of assets or working capital within the business, then there is either some mismanagement of assets or the company’s operational structure is so different from other businesses that their results are not comparable.