Calculating Cash Flow Ratios
One of the most frequently overlooked financial statements is the cash flow statement, which normally plays third fiddle to the income statement and the balance sheet.
Traditional financial statement liquidity ratios are based upon utilization of two balance sheet ratios: the current ratio (current assets/current liabilities) and the quick ratio [(cash + cash equivalents + accounts receivable)/current liabilities].
The problem with using just the balance sheet for liquidity analysis is that it presents data that measures only where a company stands at a particular point in time. And the income statement includes many non-cash allocations, accounting conventions, accruals, and reserves that don't reflect a company's true cash position.
The cash flow statement records changes in both the income statement and balance sheet while eliminating the impact of accounting conventions. What's left is what shareholders should care about most: cash available for operations and investments.
In addition, while the balance sheet ratios mentioned above measure how liquid a company was on a single date in the past, cash flow ratios can be used to evaluate how much cash a company generated over a period of time and compare that figure to its near-term obligations. The result is a more dynamic picture of what resources a company has available to meet its current financial commitments.
When computing any of the ratios discussed below, it is important to remember that the ratios are most meaningful when they are used to compare peer companies.
The operating cash flow ratio (OCF) measures a company's ability to generate the resources required to meet its current liabilities. The equation is:
Cash flow from operations/ Current liabilities.
The numerator of this fraction, which is found right on the cash flow statement, represents a company's accounting earnings adjusted for non-cash items and changes in working capital. The denominator takes into account all current liabilities found on the balance sheet.
The purpose of this ratio is to assess whether or not a company's operations are generating enough cash flow to cover its current liabilities. If the ratio falls below 1.00, then the company is not generating enough cash to meet its current commitments. In this case, the company is likely to have to find other sources to fund its operations or slow the rate at which it is spending its cash. Any existing cash balance can help the company meet these needs, but there has to be some concern about whether or not the company will be able to continue operating without raising additional funds, as the existing cash balance cannot last forever.
In some ways, it's even more important to assess whether or not a company is generating enough cash to repay its current debts. If the company defaults on these obligations, then the risk of bankruptcy increases, as does the company's risk of having its assets seized by creditors. If a company cannot meet its current debt obligations, then it's not going to be easy for it to borrow additional funds. And even in the event that it can borrow funds, the associated terms are not likely to be very favorable.
Cash current debt coverage (CCD) is a ratio that can be used to measure a company's ability to repay its current debt. CCD is calculated as follows:
(Cash flow from operations - cash dividends)/Current interest-bearing debt.
The numerator of this fraction represents a company's retained operating cash flow. (Note: cash dividends paid can be found in the "net cash used for financing" section of the cash flow statement.)
Like the OCF, if a company's CCD is less than 1.00, the company is not generating enough cash to repay its current debt obligations. The higher the multiple calculated by this ratio, the higher the comfort level you should feel when you see debt on a company's balance sheet. Of course, as long as the company is not insolvent, the appropriate level varies by the characterists of the industry.
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Traditional financial statement liquidity ratios are based upon utilization of two balance sheet ratios: the current ratio (current assets/current liabilities) and the quick ratio [(cash + cash equivalents + accounts receivable)/current liabilities].
The problem with using just the balance sheet for liquidity analysis is that it presents data that measures only where a company stands at a particular point in time. And the income statement includes many non-cash allocations, accounting conventions, accruals, and reserves that don't reflect a company's true cash position.
The cash flow statement records changes in both the income statement and balance sheet while eliminating the impact of accounting conventions. What's left is what shareholders should care about most: cash available for operations and investments.
In addition, while the balance sheet ratios mentioned above measure how liquid a company was on a single date in the past, cash flow ratios can be used to evaluate how much cash a company generated over a period of time and compare that figure to its near-term obligations. The result is a more dynamic picture of what resources a company has available to meet its current financial commitments.
When computing any of the ratios discussed below, it is important to remember that the ratios are most meaningful when they are used to compare peer companies.
The operating cash flow ratio (OCF) measures a company's ability to generate the resources required to meet its current liabilities. The equation is:
Cash flow from operations/ Current liabilities.
The numerator of this fraction, which is found right on the cash flow statement, represents a company's accounting earnings adjusted for non-cash items and changes in working capital. The denominator takes into account all current liabilities found on the balance sheet.
The purpose of this ratio is to assess whether or not a company's operations are generating enough cash flow to cover its current liabilities. If the ratio falls below 1.00, then the company is not generating enough cash to meet its current commitments. In this case, the company is likely to have to find other sources to fund its operations or slow the rate at which it is spending its cash. Any existing cash balance can help the company meet these needs, but there has to be some concern about whether or not the company will be able to continue operating without raising additional funds, as the existing cash balance cannot last forever.
In some ways, it's even more important to assess whether or not a company is generating enough cash to repay its current debts. If the company defaults on these obligations, then the risk of bankruptcy increases, as does the company's risk of having its assets seized by creditors. If a company cannot meet its current debt obligations, then it's not going to be easy for it to borrow additional funds. And even in the event that it can borrow funds, the associated terms are not likely to be very favorable.
Cash current debt coverage (CCD) is a ratio that can be used to measure a company's ability to repay its current debt. CCD is calculated as follows:
(Cash flow from operations - cash dividends)/Current interest-bearing debt.
The numerator of this fraction represents a company's retained operating cash flow. (Note: cash dividends paid can be found in the "net cash used for financing" section of the cash flow statement.)
Like the OCF, if a company's CCD is less than 1.00, the company is not generating enough cash to repay its current debt obligations. The higher the multiple calculated by this ratio, the higher the comfort level you should feel when you see debt on a company's balance sheet. Of course, as long as the company is not insolvent, the appropriate level varies by the characterists of the industry.
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posted by Bob Moser at
6:53 PM
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