# Cash flow ratios: tools for financial analysis.

INTRODUCTIONOne of the four major financial statements that are directly related to cash is the statement of cash flows. The purpose of the cash flows statement is to report inflows and outflows of cash for a given period of time. Cash flows related to operating, financing, and investing activities of a company are separately reported in the statement. This detailed disclosure of individual cash flows is important to users. Cash flows can show a company's ability to finance its expenditures from operations, pay its existing debts as they mature, and demonstrate a company's ability to meet unexpected obligations and to pursue business opportunities (Larson, Wild, & Chappetta, 2006). According to Statement of Financial Accounting Standards No. 95, "Statement of Cash Flows," the information in the statement, if used with information in other financial statements, can help investors, creditors, and others to assess an entity's ability to generate positive future net cash flows, and its ability to meet its obligations and to pay dividends, and determine its needs for external financing during the period.

Operating activities-one section of the statement of cash flows-refer to a company's basic business activities, whether it is selling, manufacturing, resale, renting, or rendering services. Positive cash flow from its operating activities is a good indicator of a company's performance. "Happiness is a positive cash flow," according to Kieso, Weygandt, and Warfield (2004), and if the cash flow is increasing through the years, it shows that the company is able to remain solvent and is able to meet its cash needs. A negative cash flow from operating activities, on the other hand, would indicate that the company is not performing well enough to sustain even its core functions.

The remaining sections of the statement of cash flows, those concerning investing (purchase and sale of assets other than the company's products) and financing (borrowings, repayments of borrowings, investments by owners, and distribution of dividends or profits to owners) reflect what the business does with its cash coming from operations, and the sufficiency of cash to meet other functions of the company. Users of financial statements look at where the company is getting its cash aside from operating activities. If most of the cash is acquired through financing activities, then the company might be in danger in the future if it could not pay off its debts. If money is used for investing activities, you can expect the money to return after some time depending on the payback period or the rate of return of the investment (White, 2004).

By examining the cash and non-cash investing and financing activities of a company, users can understand why assets and liabilities increased or decreased during a given period. It is easier to explain why there was an increase in the cash when the company was showing a net loss, the sources of funds for acquiring fixed assets, the reasons why dividends did not increase, how debts were retired, and how much money was borrowed (Kieso, et al., 2004).

In financial management, financial analyses rely primarily on ratios derived from the income statement and balance sheet data. Analyzing cash receipts and payment or sources and uses of cash are only a secondary basis for making managerial decisions and for predicting the outcome of future business activities. This stems from the belief that information from accrual accounting provided a better indication of a business's current and future ability to create favorable cash flows compared to analyzing cash receipts and payments (Bowen & Daley, 1986). However, the statement of cash flows has properties unique from income statements and balance sheets. As one of the four required financial statements, the statement of cash flows is believed to carry invaluable information essential for a complete analysis of the financial situation of a company. This information can be converted into ratios and can be useful tools in evaluating a company.

Ratio analysis is a very basic method of evaluating the financial position of a company. Ratio analysis expresses the relationship among selected items of financial statement data. Ratios, however, will only be meaningful if compared intra-company and inter-company (Weygandt, Kieso, & Kimmel, 1998). Intra-company analysis is comparing ratios within the company, while inter-company is comparing ratios between or among the same type of companies. The inter-company comparisons are more significant if they are competing companies.

This study will analyze ratios derived from the operating cash flows. These ratios are then used to analyze four years of statements of cash flows of three manufacturing corporations. The objective of the study is to test ratios derived from the statement of cash flows, use them to evaluate the intra performances of companies to determine said companies' liquidity, efficiency, profitability and ability to protect long-term investors and creditors. This study will test the usefulness of the ratios, applicability to manufacturing companies and determine if there are limitations to their uses.

The study is, first and foremost, beneficial to the academe. In particular, students and instructors of financial and/or managerial accounting. This study can serve as a benchmark for a deeper understanding of the statement of cash flows as a tool for financial analysis. It will reinforce existing knowledge concerning cash flows. The study is also meant for users of financial statements, especially those with little to no background in finance and/or accounting.

This study will help investors, lenders, entrepreneurs understand the concepts behind cash flows on how this statement will show the financial standing of a company in terms of cash. A clear and simple analysis of the information found in the statement of cash flows and how information in this statement may be utilized will help users appreciate the importance of the statement.

REVIEW OF RELATED STUDIES

Cash flows have been increasingly studied by researchers in the field of accounting and finance. Bowen, Burgstahler, and Daley (1986) studied the relationship between accrual earnings and various measures of cash flow. The primary focus of the study was to test if earnings and cash flow data were equally effective in determining future cash flows. In addition to this, the correlation between traditional cash flow measures and alternative cash flow measures and the relationship between accrual accounting earnings and cash flow measures were also determined. Results show that there is a relationship between accrual earnings and various measures of cash flow. The results showed that traditional measures of cash flow are highly correlated with earnings. There is, however, low correlation between alternative measures of cash flow and earnings. The results disproved the assertions that accrual earnings provided more accurate forecasts of future cash flows than cash flow measures. Thus, there is evidence that cash flows can be an effective and efficient instrument in forecasting the results of business operations.

Almeida and Weisbach (2004), for their part, focused on the relationship between financial constraint and a firm's liquidity demand rather than on the effects of financial constraints on corporate policies. The relationship between the two factors was used to identify whether or not financial constraints were an important determinant of firms' behavior. The study was able to propose an empirical method to test the effect of financial constraints on firms' policies through the application of the cash flow sensitivity to cash. It was able to focus on the importance of cash holdings and its management, which is necessary to pursue investment opportunities without experiencing heavy financial constraint. The study was able to show the role of cash flow management in ensuring firms' growth and survival.

Mills and Yamamura (1998) argued that when it comes to liquidity analysis, cash flows information is more reliable than balance sheet or income statement information. Balance sheet data are static--measuring a single point in time--while the income statement contains many arbitrary noncash allocations. In contrast, cash flows record the changes in the other statements and focuses on cash available for operations and investments. The study presented an interesting case study between two competing game houses or casinos. Although the two casinos' balance sheet items and ratios seemed promising, there was in fact an actual dearth in cash on hand with one of them. This problem was mostly left ignored until the company could no longer sustain itself through its operations and cover its immediate debt. There is thus clearly a need for cash flow analysis to be integrated into analyses of companies' financial positions. The study focused on understanding the statement of cash flows from the point of view of auditors.

For cash flows statements to be useful, ratios need to be derived from them in the same way that ratios are derived from income statements and balance sheets. In "Developing Ratios for Effective Cash Flow Statement Analysis," Carslaw and Mills (1991) show the emergence of a consciousness towards using cash flows ratios to help internal and external users of financial statements. It is a clear approach to the explanation of usefulness of the statement of cash flows through the use of ratios. The study suggests different ratios from the statement of cash flows that can be used to analyze the significance of the statement. They proposed four categories, each covering a different angle in business: solvency and liquidity, quality of income, capital expenditures, and cash flow returns. Except for solvency and liquidity, most of the ratios are not similar to the ratios derived from income statements and balance sheets. The study did not test the effectiveness of the ratios by analyzing a company. They also recognized the need for standardization of ratios, which would allow for better comparison of data.

Figlewicz and Zeller (1991) also identified and discussed meaningful ratios based on the statement of cash flows. Cash flow data are merged with existing financial information to complement standard ratios to measure performance, liquidity, coverage, and the capital structure of businesses. The financial reports of W. T. Company for the period 1967 through 1975 were used to analyze if the ratios provide complementary information to the analyst. It was found that the ratios complement traditional financial ratio analyses. Schmidgall, Geller, and Ilvento (1993) further proposed nine financial ratios based on the statement of cash flows. The authors discussed the usefulness of the ratios and concluded that the ratios "appear to provide reasonable supplementary information beyond what traditional ratios provide" (p. 53), after analyzing a hypothetical income statement, balance sheet and statement of cash flows.

The objective of the present study is to find out limitations in using these ratios. This study will focus on the application of the cash flow ratios in evaluating the financial position of three manufacturing companies. These ratios are derived from the operating activities of the statement of cash flows. However, there are some ratios that also require data from the income statement and balance sheet.

Three ratios in the study of Carslaw and Mills (1991), classified as solvency and liquidity ratios, are included in this study. They are: "cash interest coverage,", "cash debt coverage," and "cash dividends coverage." Ratios from Weygandt, et al. (1998), Schmidgall, et al. (1993), and Figlewicz and Zeller (1991) will also be used. Cash flow ratios are grouped under four major categories (Kieso, et al., 2004): liquidity, efficiency (activity), profitability and solvency (coverage). The ratios are summarized in Table 1.

A. Liquidity ratios measure a company's short-run ability to pay its maturing obligations (Kieso, et al., 2004). Short-term creditors such as bankers and suppliers are interested in assessing liquidity (Weygandt, et al., 1998). It is affected by the timing of cash inflows and outflows along with prospects of future performance (Larson, et al., 2006). Common ratios to measure liquidity are the current ratio and acid test ratio. These ratios are based on accrued data and are calculated at a particular point of time. Using data from the cash flows will correct this deficiency (Schmidgall, et al., 1993). The following cash flow ratios will measure liquidity of a company.

1. Operating Cash Flow Ratio: cash flow from operations / current liabilities (Figelwicz and Zeller, 1991; Mills, et al., 1998; Schmidgall, et al., 1993). Tests how much cash was generated over a period of time and compares that to near-term obligations. Data will come from the statement of cash flows and balance sheet. Casey and Bartczak (1985) suggest 40% or more is common for healthy firms.

2. Cash Ratio: cash/current liabilities. The cash ratio measures the portion of short term debt that can be paid using available cash. This ratio determines cash available to cover current liabilities. Data will come from the balance sheet. The higher the ratio, the better is the coverage of the current liabilities.

3. Cash Debt Coverage Ratio: cash flow from operation-dividends / total debt (Carslaw & Mills, 1991; Figelwicz & Zeller, 1991; Schmidgall, et al., 1993; Weygandt, et al., 1998). The cash debt coverage ratio shows the percent of debts that current cash flows from operations (less dividends) can retire. It is the ability of the company to satisfy debt payments with the use of cash derived from operations less dividends given to shareholders. Data will come from statement of cash flows and balance sheet. Davidson, Stickney, and Weil (1988) suggest that 20% or higher is reasonable.

4. Cash Interest Coverage: cash flow from operations + interest / interest (Carslaw, et al., 1991; Figelwicz & Zeller, 1991; Schmidgall, et al., 1993). This ratio indicates the cash actually available to meet interest charges. Data will come from the statement of cash flows. The higher the ratio, the better the company's ability to service its debt.

B. Efficiency or activity refers to how productive a company is in using its assets. Common ratios based on accrual data are asset turnover, receivable turnover, and inventory turnover. Cash flow activity ratios measure a company's ability to utilize its existing assets. Using these ratios will help an analyst monitor the production of cash from operating activities free of the potential accrual accounting distortions (Figelwicz & Zeller, 1991). The following cash flow ratios will measure efficiency using cash flow data.

1. Cash Return on Assets: cash flow from operations / average total assets (Figelwicz and Zeller, 1991). This ratio indicates the percentage of cash generated from using total assets. This ratio directly measures the cash flows from operating activities generated from the company's assets. The higher the ratio, the better the company is in using its assets.

2. Cash Return on Fixed Assets: cash flows from operations / average total fixed assets. This ratio indicates the percentage of cash generated from using total fixed assets. The objective of this ratio is to measure cash generated by using fixed assets. The higher the ratio, the better the company is in using its assets. Data will come from the statement of cash flows and balance sheet.

3. Cash Reinvestment Ratio: increases in fixed assets and working capital / (net income + depreciation (Schmidgall, et al., 1993). This ratio measures the degree to which net income in the form of cash is reinvested into the business. The ratio is useful for measuring the percentage of the investment in assets that is available to be reinvested in both asset replacement and expansion. The higher the reinvestment, the greater the expected future cash flows from operations. Data will come from the balance sheet, the income statement and statement of cash flows.

4. Cash Turnover: cost of sales {excluding depreciation}) / available cash. This will show the number of times cash turns over in a year. The more number of turnovers, the more revenues cash can generate. Data will come from the income statement and the balance sheet.

5. Cash Balance or Days Cash Balance: available cash x 365 days / (cost of sales [excluding depreciation]). This ratio, giving cash turnover in number of days, complements cash turnover. The fewer days indicated by the ratio, the better for the company.

C. Profitability or operation refers to a company's ability to generate an adequate return on invested capital. The ratios measure a company's degree of success or failure in its operation. Income or the lack of it affects the company's ability to obtain loans, its liquidity position, and its ability to grow (Weygandt, et al., 1998). An analyst examines operations ratios such as percentage cost of sales and profit margin. The following cash flow ratios will help in measuring profitability:

1. Earnings Quality: cash flow from operations / net income (Figelwicz & Zeller, 1991; Schmidgall, et al, 1993). This ratio measures the collect ability of net income. It is the percentage of net income converted to cash. A ratio higher than one signifies ability of the company to convert receivables to cash during the period. Data will come from the statement of cash flows and the income statement.

2. Cash Flow from Sales to Sales: cash flow from operations--dividends / total sales). This ratio is almost the same as cash return on sales ratio (Weygandt, et. al, 1998). This ratio indicates the degree to which sales generate cash retained by the business. A positive ratio indicates the generation of cash flow from sales. Data will come from the statement of cash flows and the income statement.

3. Cash flow margin: cash flow from operations / total revenues (Figelwicz & Zeller, 1991; Schmidgall, et al, 1993). This is similar to the profit margin. However, instead of net income, cash flow margin will use cash flow from operations to show the percentage of cash flows from operation over the total revenues. The higher the cash flow, the better a company is able to translate sales into cash. Data will come from the statement of cash flow and the income statement.

D. Coverage or solvency refers to a company's long-run financial viability and its ability to cover long-term obligations. It measures the degree to which long-term creditors and investors are protected (Kieso, et al., 2004). A positive ratio indicates a company's ability to protect its investors and creditors. Common ratios used by analysts are: Debt to total assets ratio, times interest earned and book value per share. The following cash flow ratios will measure coverage.

1. Cash Flow to Long Term Debts: cash flow from operations / long term debts (Figelwicz & Zeller, 1991; Schmidgall, et al, 1993). The ratio appraises the adequacy of available funds to pay long-term obligations. This ratio is similar to "cash debt coverage ratio" (Weygandt, et al., 1998); net cash provided by operating activities/ average total liabilities. However, instead of using average total liabilities, the proposed ratio will use long-term debts. The higher the ratio, the better a company is able to cover long term debts out of its cash flow from operations. Data will come from the statement of cash flows and the balance sheet.

2. Cash Dividend Coverage Ratio: cash flow from operations / dividends (Figelwicz & Zeller, 1991). This ratio measures the company's ability to pay dividends from cash derived from operations. This ratio is important to investors, owners and potential owners of the company. An increasing trend will indicate the company's ability to provide returns for them. Data for this will come from the statement of cash flows.

3. Cash Return to Shareholders: cash flow from operations / shareholder's equity (Figelwicz & Zeller, 1991). This ratio indicates the amount of cash generated from shareholders' investments. An investor is interested in the cash return of equity. The ratio will indicate the future return on equity, which prospective investors will be interested in knowing. The ratio is similar to "return on common stockholders' equity" (Weygandt, et al., 1998), net income / average common stockholders' equity. However, the cash flow ratio will use total shareholders' equity. An increasing trend is a good indicator of the future return on equity. Data will come from the statement of cash flows and the balance sheet.

4. Cash Flow per Share: Cash flow from operation / average number of common shares outstanding (Schmidgall, et al, 1993). Indicates the earnings per share (EPS) directly related to cash flows. This ratio will complement the EPS ratio. An increasing trend is a good indicator of the future return to stockholders.

The ratios are tested by analyzing the statement of cash flows of AM Corporation, UR Corporation and RM Corporation for the years 2004, 2005, 2006, and 2007. Four years of intra-company will be made to test if the ratios can be used to gauge the performances of the companies. These companies are engaged in food manufacturing and are considered to be competitors.

The first company, AM Corporation, was founded in 1972 and is based in Makati, Philippines. The company's principal activity is manufacturing, distributing, and selling liquid, powdered, and ultra-heat treated milk products. It distributes its products to major supermarkets and groceries, wholesalers, mini-groceries, market stalls, and convenience stores nationwide.

UR Corporation was founded in 1954 and is based in Quezon City, Philippines. The company manufactures and distributes snack foods, candies, chocolates, and animal feeds. The company operates in 3 segments: branded consumer foods, agro-industrial, and commodity food products. It sells its branded food products primarily to supermarkets, wholesalers, convenience stores, large scale trading companies in the Philippines, Thailand, Malaysia, Indonesia, China, Hong Kong, Singapore, and Vietnam.

Finally, RM Corporation is engaged in the manufacture and marketing of flour-based mixes, pasta, canned and processed meat, milk, and juices. The company also manufactures, distributes, imports, and exports ice-cream desserts and ice cream novelties, and similar goods. The food business operation focuses on the wholesale market, such as restaurants, foods chains, supermarkets, etc.

A. Liquidity or solvency

The ability of AM Corporation to cover its current liabilities is shown in its operating cash flow ratios (Table 2). The company's ability to pay current liabilities out of its operating cash was good in 2004 and 2006, showing more than 40% in those years. In 2005, the ratio was down to 19.1% and in 2007 the company registered negative cash flows from its operating activities. If the trend continues and the company will depend on its cash flows from operating activities to cover its current liabilities, the company will not be able to settle its current liabilities. Current creditors should be worried about the company's ability to pay its short term debts on time in the future.

The percentage of AM Corporation available cash to cover its current liabilities is shown in its cash ratios. AM Corporation's cash ratios in 2004 and 2005 were more than 100%. Available cash was more than the company's current liabilities in 2004 and 2005. However, in 2006, the company's cash ratio decreased tremendously to 19.7%. Available cash was not enough to cover its existing current liabilities in 2006. The ratio further decreased in 2007 to only 4% available cash to cover current liability. Reviewing the uses of cash in its investing and financing activities will help in the analysis of cash ratios.

Cash debt coverage ratios of AM Corporation show that 27.4% of the total debts (current and long-term debts) could be covered in 2004 and 33.5% of the total debts in 2006, while in 2005 and 2007 the company did not appear to be able to pay any of its creditors using cash from operations alone.

Cash from operations as a gauge to pay interest is shown in AM Corporation's cash interest coverage ratios. Cash from operations were sufficient to meet payments of interest from 2004 through 2006; the ratios were more than 1.0. However, in 2007 the company could not rely on its cash from operations to pay interest.

In terms of liquidity, the ratios show that the company was in the best position to satisfy short term debts with the use of cash in 2004. In 2005 and 2006, there were decreases in cash due to lower cash from operating activities which lowered the firm's ability to satisfy current liabilities.

There is a need to further analyze the statement of cash flows to find out the causes of the changes in the liquidity position of the company, and also to find out if other sources of cash were utilized to supplement its decreasing cash from operations. Further review shows that income before working capital changes was highest in 2007 at P1.2B. However, the funds were used to finance the increases in inventories, prepaid expenses and other current assets. The company also doubled its trade and other receivables. In 2006, the company used P1.8B to cover its investing activities. In 2007, the company had to generate cash outside of its operating activities to become liquid. Additional loans of P800M were acquired. This additional cash made it possible for the company to meet its current liabilities.

The four liquidity ratios can measure the solvency of the company. Cash ratio can be compared to quick ratio as a more intense measurement of the company's ability to meet current liabilities. It should be noted that any ratio that is based on operating cash flows when the data is negative will give a negative ratio, which cannot be used to analyze the company.

B. Efficiency or activity

Cash return on assets, cash return on fixed assets, cash reinvestment ratio, cash turnover and turnover of cash in number of days are tested as measurements for efficiency.

Cash return on total assets and total fixed assets indicate the degree of the contribution of assets to operating cash flows. In 2004 and 2005, total assets contribution to generate operating cash for AM Corporation were 15.1% and 5.1%, respectively, while the ratio improved in 2006 by 11.2%. The contribution of fixed assets in generating cash flows for operating activities decreased from a high 87.6% in 2004 to 25.3% in 2005. It improved in 2006 to 78.1%. In 2007 the company is showing negative ratio since cash flow from operating an activity was negative.

The cash reinvestment ratio measures the degree to which net income in the form of cash can be reinvested invested into the business. The acceptable percentage is 8% to 10%. Using 2004 as the base year, AM Corporation cash reinvestment ratios in 2005 and 2006 are above the acceptable percentage. The ratio in 2007 showed a negative value of -1.587 because the net increase in working capital was lower in 2007 than in 2006. The company was not capable of reinvesting its cash in 2007. A review of the statement of cash flows shows that the company's increase in inventory that year was the reason behind its negative cash flows from operation.

The company was very efficient in its cash turnover ratios. Cash turned over 1.895 times in 2004, 2.558 times in 2005, 12.097 times in 2006 and a big leap of 47.275 times in 2007. There was a drastic increase in 2006 which implied that cash was more efficiently used to generate more sales and profit. The high cash flow from operations in 2006 corresponded to the high cash turnover. The company recorded the highest sales and highest net income in 2007. Likewise their cash balance improved from 193 days in 2004, to 143 days in 2005, to 30 days in 2006 and 8 days in 2007. The company made used of their cash efficiently, particularly in 2006 and 2007.

The return on total assets and total fixed costs ratios were able to present the degree of contribution of assets to cash flows while cash reinvestment ratio was able to show the percentage of cash that can be reinvested into the business. Cash turnover ratio and days cash balance will be very useful in analyzing the efficiency of the company. These two pieces of information can easily be understood by both internal and external users.

C. Profitability or operation

AM Corporation's earnings quality ratio was highest in 2006 because of high cash flows generated from operations and lowest in 2005. Since 2007 had negative cash flows from operations, it is implied that the company was not able to convert any portion of its sales to cash.

Cash flows from sales to sales were positive in 2004 and 2006 which implied that sales were effectively generating cash. The ratio was highest in 2006, corresponding to the high cash flows from operations, which was related to sales generation. The ratio was lowest in 2005 followed by 2007, which were supported by the low cash or negative cash from operations in those years. Although sales in 2005 were higher than sales in 2004, sales from 2005 were not effectively converted into cash resulting in a negative cash balance after the distribution of dividends. Likewise the same analysis is noted for 2007. The statement of cash flows shows that there were increases in receivables, inventories, and in trade and other payables in 2007.

Cash flow margins ratio shows the relationship between sales and cash flows from operations. This is the ability of a company to translate sales into cash. AM Corporation is showing a ratio of 14.2% in 2006, followed by 12.8% in 2004 and 4.3% in 2005. Cash flow margin ratio in 2007 is -4.3%. The company was able to generate cash from sales in year 2006 better than in any other year. This was supported by the large amount of cash generated from operations that year. If these ratios are indicative of the percentage of sales convertible into cash, then it would show that the company was not able to convert any portion of the sales into cash in 2007, which is not true.

The three profitability ratios cannot fully gauge the operation of the company. Interpreting the ratios and understanding the relationship between sales and cash from operating activities might be confusing to external users. The ratios can be used to supplement other accrued profit ratios derived from income statement.

D. Coverage or leverage

Cash flows to long-term debt, cash dividend coverage, and cash return to shareholders and cash flow from investing to operating are measurements of the ability of the company to protect its creditors and investors.

Since AM Corporation was not showing any long-term debts, cash flows to long term debts ratios cannot be determined. Cash dividends coverage ratio shows the ability of the company to pay dividends from its operating activities. Cash flows from operations were sufficient to meet dividend payments in 2004 and 2006. In 2005, cash from operations were barely enough to pay for dividends. The ratio decreased in 2005 because of the low cash from operations. The ratio greatly increased in 2006 due to increased cash from operations. Based on these data, the company was best able to pay its dividends in 2006. If the company will depend on its operating cash to pay dividends, then the company will not be able to pay for dividends in 2007 because it is showing negative cash flows from operations. Further analysis however, shows that the company had the highest net income in 2007 and it was able to distribute dividends. Cash coming from other financing activities made it possible for the company to pay dividends.

Cash return to shareholders ratio indicates the amount of cash from operations that is earned through the effective use of shareholder funds. AM Corporation's cash return to shareholders ratio was lowest in 2005 due to low cash from operations and highest in 2006 due to a more efficient use of funds to generate a higher cash return for shareholder investments. In 2007 the ratio is negative because, as mentioned earlier, cash from operations is negative. The negative ratio implies that there is no cash return to shareholders in 2007. The trend of cash flow per share ratios is following the trend of cash return to shareholders' ratios. Although the trend went down in 2005, it went up again in 2006. The ratios in 2004 (66.7%) and 2006 (86.9%) show that cash flow operations during these periods are more than one half of the shareholders' equity. The ratio went down in 2005 to 22.5%.

The four ratios tested can show the ability of the company to protect its creditors and investors as long as cash flow from operation is not negative. It must be pointed out that the ratios needed further review of the statement of cash flows to determine if the other activities (investing or financing) are required or help in the payment of dividends.

A. Liquidity or solvency

Table 3 shows the ratios for UR Corporation. The trend of the operating cash flow ratio is stable. The ratios are close to the acceptable rate of 40%. The ratios are showing slight decreases from 2004 through 2007. The ability of UR Corporation to pay current liabilities from its available cash is shown in its cash ratios. It is a roller-coaster trend. The ratios show that in 2004, 26.4% of the current liabilities could be settled using available cash, which decreased to 12.3% in 2005. The ratio improved in 2006, when the company could afford to settle almost one half (51.3%) of its current liabilities out of its available cash. The company was able to pay a larger portion of short term debts in 2006 due to increases in net operating cash flow and in their financing activities. Although in 2007 the ratio again decreased to 35.7%, the ratios for 2006 and 2007 are better than those for 2004 and 2005.

The cash debt coverage ratio decreased from 2004 (11.9%) to 2005 (6.3%), increased slightly in 2006 (7.6%) and again decreased in 2007 (6.6%). The ratios are not within the acceptable range of 20%. This ratio is a more intense test than operating cash flow ratio of the ability of the company to pay their debts. If the trend of the ratios continues, the company will need other sources of funds to pay off debts.

The company's ability to pay interest related to debts is excellent as shown in its cash interest coverage ratios. The company had more than 200% cash to pay interest .for 4 years. In all three years, the company generated sufficient cash flows from operations to pay interest.

In terms of liquidity, the company was in the best position to pay current debt in 2006, which was caused primarily by the large overall increase in cash. The company was more liquid in 2006 than in other years because of cash flows generated from its operating activities. Although cash from operations was highest in 2006, it did not place the company in a better position to pay current debt because of similarly larger debt compared to 2004 and 2005.

Analysis of the statement of cash flows shows that in 2006 more than P1M was allotted to dividends which resulted in lesser cash to satisfy a significantly larger amount of debt. The company gave a higher priority to payment of dividends than to settling its debts. The ratios clearly show the liquidity of the company.

B. Efficiency or activity

The cash return on assets ratio was lowest (4.3%) for UR Corporation in 2005 because of the increase in total assets from 2004 to 2005. The highest ratio was in 2004 at 6.6%. The cash return on assets was relatively the same in 2006 and 2007 at 5.7% and 5.2% respectively.

The trend is not increasing and improving.

The trend on cash return on fixed assets is stable and ranged from 12.5% to 16.6%. The cash return on fixed assets was lowest in 2005 due to the increase in total fixed assets from 2004 to 2005 in the absence of an increase in cash flow from operations. It was highest in 2004 showing the contribution of fixed assets in operating cash flows at 16.6%.

Using 2004 as the base year, only three years' cash reinvestment ratios can be compared. None of the ratios were within the acceptable range of 8% to 10%. The year 2005 proved to be the best year, showing the highest ratio of 3.075, which implied that more cash was reinvested in the business. The company's ability to reinvest was reduced in 2006, and in 2007 the company did not increase its fixed assets and working capital. Increases or decreases in working capital and fixed assets could be attributed to other factors not readily shown in the statement of cash flows.

Cash turnover ratio was highest in 2005 (23.264 times) and lowest in 2006 (4.075 times). Days cash balance was highest in 2006 (89.58 days) and lowest in 2005 (15.69 days). This shows that the ability of company to turn over its cash has no effect on the number of days cash balance.

The four ratios can show the efficiency of the company if an analyst will rely on the trends of the ratios. However, increases or decreases in working capital and fixed assets could be attributed to other factors not readily shown in the statement of cash flows. Still the cash turnover ratio and days' cash balance are two efficiency measurements that can easily be understood.

C. Profitability or operation

Conversion of net income into cash is shown in a company's earnings quality ratio. UR Corporation's ratios for 2004 and 2006 were more than 100%. It had the highest ratio of 1.532 in 2004 despite lower cash flows from operations, as compared to 1.160 in 2006. The ratio was higher because of lower net profit. In 2006, the percentage of cash flows to net income was lower because the increase in cash flows was not in proportion to the increase in net income. Both years indicated that cash was more than the net income. Net income in 2005 was almost the same as cash (98.9%) while in 2007, net income was only 55.8% of cash. It is a good indicator of the company's quality of earning.

Cash flow ratio from sales to sales was also highest in 2004 (8.7%). This implied that 8.7 % of the sales are equivalent to cash. In 2006, although cash flows from operations was higher than 2004, sales was equivalent to 6.2% of cash, which was almost the same as 2005 (6.0%). In 2007 cash was equivalent to 4.1% of sales.

Cash flow margin ratios decreased from 10.6% in 2004 to 7.6% in 2005, slightly increased to 9.6% in 2006, and slightly decreased to 8.1% in 2007. Although the trend is not increasing, the ratios are positive and imply that the company has the ability to translate its cash to sales. Examination of its receivables is encouraged to determine the causes of the trend.

In terms of profitability, the company was best able to generate cash from sales in the year 2004. Although the cash flow from operations was lowest, the percentage of cash converted from sales and net income was highest in 2004. The high cash flows in 2006 did not correspond to an efficient conversion of sales and net income to cash.

Interpreting the cash flow profitability ratios is confusing. The relationship of operating cash flow to net income and to sales may not be meaningful to external users, not as significant if the analyst used the accrued ratios.

D. Coverage or leverage

The decrease in UR Corporation's cash flow to long term debt from 2004 to 2005 was primarily because the amount of long term debts doubled in 2005. The ratio decreased in 2006 because the company generated cash from operations and financing activities that was sufficient to pay a larger portion of the debt. The ratio was highest in 2007 at 32.3%. The trend of the ratio is increasing. It is a good indicator of the company's capability to cover its long term debts from operational cash flow.

The company can fully cover payment of dividends. Cash dividends ratios are consistently more than 1. There was a big decrease in the ratio from 2005 to 2006 because the dividends paid were twice the amount paid in the previous two years.

The percentage of cash as against shareholders' equity is shown in its cash return to shareholders ratios. Cash return to shareholders was lowest in 2007 due to lower cash from operations. The ratio was highest in 2004 (12.9%) because of high cash flows corresponding to the increase in stockholders' equity. Although the trend is not increasing, the company can pay its dividends out of its cash flow from operations. Likewise, the cash flow per share ratios are not increasing, though the ratios are all more than 100%, which are good indicators as far as cash flow per share is concerned.

The coverage ratios clearly show UR Company's ability to pay long term debts and protect its investors.

A. Liquidity or solvency

The operating cash flows ratios (Table 4) of RM Corporation will discourage creditors. All ratios are below 40%. The best year was 2006, at 15.8%. The year 2005 registered the lowest at 0.3%. These years' performances are indicators that the company could not settle their debts in time if the company relied solely on its operating cash flows. As shown in the statement of cash flows, cash flows from operations went from a high of P640.784M in 2006 down to P163.048M in 2007.

The portion of short term debts of RM Corporation that can be paid using available cash is shown in the cash ratios. These ratios go up and down for RM, from 1.12% in 2004 to 14.8% in 2005, to 13.7% in 2006 and 15.8% in 2007. The cash ratio was highest in 2007. This was primarily because available cash increased by P130M in 2007 as compared to available cash in 2006.

Except for 2006 when the cash debt coverage ratio was at 12.9% due to the high cash generated from operating activities, all other years the ratios were only at 3%. All ratios are below 20%. It was lowest in 2005 due to the low cash derived from operations. This is an indicator that the company will have a difficult time settling either short or long-term liabilities if the company will rely entirely on cash from its operating activities. Although cash from operations will make it difficult to settle obligations, cash will be more than enough to pay interest on debt. Cash interest coverage ratios are more than 100%.

In terms of liquidity, the ratios show that the company was in the best position to pay debts in 2006. There is a need to examine the other portions of the statement to determine the causes of the increases or decreases in the ratios which the ratios cannot show.

B. Efficiency or activity

The cash return on assets for RM Corporation was highest in 2006. This was due to the large amount of cash generated from operations. It was lowest in 2005 because the cash from operations was much lower compared to 2004 and 2007. The ability of the company to efficiently convert its assets into cash is low, the highest being 6.8%. The cash return on fixed assets followed a similar pattern.

The cash reinvestment ratios were negative in 2005 and 2006, which implied a decrease in fixed assets and working capital during those years. Because of these decreases, it can be assumed that cash reinvested into the business was insufficient to increase fixed assets and working capital. The ratio was above 1 in 2007 and more than the 40% acceptable ratio. If this ratio is going to be the basis of their performance in the future, then it can be said that the company will be doing better. Examination of the other portions of the statement of cash flows shows that there was an increase of cash generated from its investing activities in 2007. The company reported proceeds from sales of investments, fixed assets, and sale of installment contract receivables.

Cash turnover was highest in 2004 which was showing the lowest cash balance. Cash was efficiently used to increase productivity in 2004. Other years' ratios are not far from 2004's turnover of 9.957. Although the trend is not increasing yearly, all ratios are more than 100% and therefore indicate the company is doing well in terms of cash turnover. The trend of the cash balance will follow the trend of cash turnover. The year 2004 showed the lowest number of days at 36.658. In terms of efficiency, the company was most efficient in 2004.

The most useful ratios in showing efficiency of the company are the cash turnover and days' cash balance ratios. Analyzing the two other ratios, cash return on assets and cash reinvestment will be easier if they can be compared to standards pertaining to these ratios.

C. Profitability or operation

RM Corporation's earnings quality was negative in 2004 because the company experienced a net loss that year. Earnings quality was highest in 2006 due to high cash flow from operations. The value 3.163 indicates that cash flow from operations was 3 times more than net income. This is significant when compared against the 0.06 in 2005 and 0.696 in 2007. Likewise, cash flow from sales to sales was highest in 2006 due to high cash flows from operations. Ten percent (10.4) of sales was converted to cash compared to 2.8% in 2004, 0.2% in 2005, and 2.3% in 2005. In terms of profitability, the company was efficient in using its assets in 2006. The quality of earnings was excellent and was best able to generate cash from sales. This was supported by the large amount of cash generated from operations that year.

Testing cash profitability ratios in this company is easier than the other two companies. However, as mentioned earlier, these ratios are better used as supplements to the accrual basis profitability ratios.

D. Coverage or leverage

In terms of coverage, cash flow from operations of the company was able to meet 69.6% of its long terms debts in 2006. This was the year when the company registered the highest cash flows from operations and the lowest amount of long-term debts. This was also the year when the cash return to shareholders investment was highest at 14.3%. Although the company did not show any dividends payment, the company could have afforded to pay the dividends with their available cash. Likewise, cash flow per share follows the same trend as the other ratios. The year 2006 showed excellent ratios. The best year in terms of coverage or leverage was 2006, although 2007 was much lower than 2006.

RM Corporation was in the best financial position in the year 2006 despite a net decrease in cash. This was because of the large amount of cash flow from operations which enabled the company to meet its obligations to satisfy its shareholders and creditors. In addition, RM Corporation was able to make best use of its assets to generate cash profit and sales in the year 2006.

The ratios show the ability of the company to pay for its long term debts and pay dividends to its shareholders.

CONCLUSIONS

This paper tested the use of ratios derived primarily from statements of cash flows in analyzing the performance of manufacturing companies. It showed how these ratios could be useful in analyzing the financial status of a manufacturing company, if the ratios can be understood by users without the help of the income statement balance sheet.

In intra-company analyses, liquidity ratios are useful to short term creditors. It is important to current lenders to know if cash flow from operations is enough to cover the company's indebtedness and enough to cover interest payments. If cash flow from operations is not sufficient to cover current debts, there is a need to further analyze the statement of cash flows to find out the causes of the changes in the liquidity position of the company, and also to find out if other sources of cash were utilized to supplement cash from operations. Although cash flow ratio data are coming from the balance sheet, the ratio is needed to supplement the other liquidity ratios. Cash flow ratios are a more intense measurement of the liquidity of a business. This is comparable to the quick ratio. Liquidity ratios however, will be insignificant if there is no cash flows generated from operations or cash flows is negative. In this situation, the ratios cannot be used to analyze the liquidity of a company. Analyst will have to use the standard ratios using accrued data.

Efficiency ratios are useful to both internal and external users. The company's ability to reinvestment is influenced by fixed assets and working capital. Increases or decreases in working capital and fixed assets could be attributed to other factors. There is a need to look at these factors. Cash turnover and cash balance or days' cash balance will be helpful in evaluating the efficiency of a company. These ratios will be helpful in determining the ability of a company to use cash for other purposes.

Although the profitability ratios are useful to both internal and external users, interpreting the ratios are confusing particularly to external users who may not have enough knowledge of accounting. Cash return on assets and on fixed assets are good indicators of the ability of a company to generate operating cash; however, a company's ability to make use of its assets is not a guarantee that there will be enough cash to meet the company's other obligations. The percentage of net income converted to cash (earnings quality) and a higher ratio indicating cash flow from sales are better measurements of the profitability of a company. The help of other accrued ratios like gross profit margin and net profit margin will strengthen the cash flows profitability ratios.

Coverage or solvency ratios are important to long-term creditors and investors. It is important to the creditors and investors to determine when a company can pay its long-term debts or give dividends through its current operating cash flows. The proposed ratios cash flow to long term debts and cash dividends coverage ratio can be used to determine coverage. The ability of the company to make use of their shareholders' investment can be determined by the cash return to shareholders' ratio.

Except for the exceptions mentioned above, the ratios can be helpful in determining liquidity, efficiency, profitability and solvency of a company. However, it should be pointed out that since the basis of the ratios is operating cash flows, it is highly probable that the data will be negative. Negative ratios as against positive ratios cannot be used to determine the performance of a company. In such a case, use of standard accrued ratios derived from the income statement and balance sheet will be better.

REFERENCES

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Venus C. Ibarra, Ateneo de Manila University

Table 1: Summary of Cash Flows Ratios Ratio Formula Purpose A. Liquidity or solvency--measures the company's short-run ability to pay its maturing obligations Operating Cash Cash flow from Measures whether cash Flow Ratio operation/ current flows from operations Liabilities will be sufficient to meet current obligations. Cash Ratio Available cash/Current Measures the portion of Liabilities the short term debts that can be paid using available cash. Cash Debt (Cash flow from Shows the % of debt Coverage Ratio operations-- that current cash flow dividends)/Total debt can retire. Cash Interest (Cash flow from Indicates the cash Coverage operations + actually available to interest)/Interest meet interest B. Efficiency or activity--measures the ability of the charges, company in using its assets Cash Return on Cash flow from Indicates the % of cash Assets operations/ total generated from using assets total assets. Cash Return on Cash flow from Indicates the % of cash Fixed Assets operations/ Total fixed generated from using assets fixes assets. Cash Increases in fixed Measures the degree to Reinvestment assets and working which net income in the Ratio capital/(Net income + form of cash is depreciation) reinvested into the business. Cash Turnover Cost of sales Indicates the number of (excluding times cash turns over depreciation)/Available in a year. cash Cash balance or (Available cash x 365 Shows Cash turnover in Days cash days/ Cost of sales number of days. balance (excluding depreciation) C. Profitability or operation--measures the degree of success or failure of a company for the period Earnings Cash flow from Measures collectivity Quality ratio operations/ net income of net income; % of net income converted into cash. Cash Flow from (Cash flow from Indicates the degree to Sales to Sales operations-- which sales generate dividends)/Total Sales cash. Cash Flow Cash flow from Show the ability to Margin operations/ Total Sales translate sales into cash D. Coverage or leverage--measures the degree of protection for long-term creditors and investors Cash Flow to Cash flow from Appraises the adequacy Long Term operations/ Long-term of available fluids to Debts Debts pay long-term debts. Cash Dividends Cash flow from Measures the ability to Ratio operations/ Dividends pay dividends from cash derived from operations Cash Return to Cash flow from Measures the % of cash Shareholders operations/ from operations to Shareholders' equity shareholders' equity Cash Flow per Cash flow from Determines the earnings share operations/Ave. no. of per share directly commons shares related to outstanding cash flows Ratio Measurement A. Liquidity or solvency--measures the company's short-run ability to pay its maturing obligations Operating Cash 40% or more Flow Ratio Cash Ratio Increasing trend, the higher the better Cash Debt 20% or more Coverage Ratio Cash Interest Increasing trend, Coverage the higher the better B. Efficiency or activity--measures the ability of the charges, company in using its assets Cash Return on Increasing trend, Assets the higher the better Cash Return on Increasing trend, Fixed Assets the higher the better Cash 8 to 10% Reinvestment Ratio Cash Turnover The more number of times the better Cash balance or The lesser the Days cash number of days balance the better C. Profitability or operation--measures the degree of success or failure of a company for the period Earnings Increasing trend, Quality ratio the higher the better Cash Flow from Increasing trend, Sales to Sales the higher the Cash Flow better Increasing Margin trend, the higher the better D. Coverage or leverage--measures the degree of protection for long-term creditors and investors Cash Flow to Increasing trend, Long Term the higher the Debts better Cash Dividends Increasing trend, Ratio the higher the better Cash Return to Increasing trend, Shareholders the higher the better Cash Flow per Increasing trend, share the higher the Table 2: Cash Flow Ratios of AM Corporation RATIOS 2004 2005 LIQUIDITY OR SOLVENCY RATIOS Operating Cash Flow Ratio 0.470 0.191 Cash Ratio 1.353 1.376 Cash Debt Coverage Ratio 0.274 -0.023 Cash Interest Co vera se 7.994 4.161 EFFICIENCY OR ACTIVITY RATIOS Cash Return on Assets 0.151 0.051 Cash Return on Fixed Assets 0.876 0.253 Cash Reinvestment Ratio NA 0.415 Cash Turnover Ratio 1.895 2.558 Cash Balance or Days Cash Balance 192.660 142.709 PROFITABILITY OR OPERATION RATIOS Earnings Quality 1.049 0.721 Cash Flow front Sales to Sales 0.075 -0.005 Cash Flow Margins 0.128 0.040 COVERAGE OR LEVERAGE RATIOS Cash Flow to Long Term Debt NA NA Cash Dividend Ratio 2.396 0.893 Cash Return to Shareholders 0.221 0.070 Cash Flow per share 0.667 0.225 RATIOS 2006 2007 LIQUIDITY OR SOLVENCY RATIOS Operating Cash Flow Ratio 0.468 -0.115 Cash Ratio 0.197 0.040 Cash Debt Coverage Ratio 0.335 -0.192 Cash Interest Co vera se 10.455 -8.688 EFFICIENCY OR ACTIVITY RATIOS Cash Return on Assets 0.163 -0.055 Cash Return on Fixed Assets 0.781 -0.312 Cash Reinvestment Ratio 0.337 -1.587 Cash Turnover Ratio 12.097 47.275 Cash Balance or Days Cash Balance 30.172 7.721 PROFITABILITY OR OPERATION RATIOS Earnings Quality 2.082 -0.584 Cash Flow front Sales to Sales 0.101 -0.072 Cash Flow Margins 0.142 -0.043 COVERAGE OR LEVERAGE RATIOS Cash Flow to Long Term Debt NA NA Cash Dividend Ratio 3.512 -1.491 Cash Return to Shareholders 0.251 -0.104 Cash Flow per share 0.869 -0.403 Table 3: Cash Flow Ratios of UR Corporation RATIOS 2004 2005 LIQUIDITY OR SOLVENCY RATIOS Operating Cash Flow Ratio 0.340 0314 Cash Ratio 0.264 0.123 Cash Debt Coverage Ratio 0.119 0.063 Cash Interest Coverage 2 967 2.395 EFFICIENCY OR ACTIVITY RATIOS Cash Return on Assets 0.066 0.043 Cash Return on Fixed Assets 0.165 0.125 Cash Reinvestment Ratio NA 3.075 Cash Turnover Ratio 8.187 23.264 Cash Balance or Days Cash Balance 44.584 15.69 PROFITABILITY OR OPERATION RATIOS Earnings Quality 1.532 0.989 Cash Flow from Sales to Sales 0.087 0.060 Cash Flow Margins 0.106 0.076 COVERAGE OR LEVERAGE RATIOS Cash Flow to Long Term Debt 0.251 0.108 Cash Dividend Ratio 5.680 4.695 Cash Return to Shareholders 0.129 0.098 Cash Flow per share 1.704 1.408 RATIOS 2006 2007 LIQUIDITY OR SOLVENCY RATIOS Operating Cash Flow Ratio 0.289 0.217 Cash Ratio 0.512 0.357 Cash Debt Coverage Ratio 0.076 0.066 Cash Interest Coverage 2.365 2.897 EFFICIENCY OR ACTIVITY RATIOS Cash Return on Assets 0.057 0.052 Cash Return on Fixed Assets 0.144 0.131 Cash Reinvestment Ratio 0.016 -0.468 Cash Turnover Ratio 4.075 5.032 Cash Balance or Days Cash Balance 89.58 72.531 PROFITABILITY OR OPERATION RATIOS Earnings Quality 1.160 0.558 Cash Flow from Sales to Sales 0.062 0.041 Cash Flow Margins 0.096 0.081 COVERAGE OR LEVERAGE RATIOS Cash Flow to Long Term Debt 0.201 0.323 Cash Dividend Ratio 2.816 2.032 Cash Return to Shareholders 0.108 0.088 Cash Flow per share 1.519 1.382 Table 4: Cash Flow Ratios of RM Corporation RATIOS 2004 2005 LIQUIDITY OR SOLVENCY RATIOS Operating Cash Flow Ratio 0.037 0.003 Cash Ratio 0.112 0.148 Cash Debt Coverage Ratio 0.029 0.003 Cash Interest Coverage 4.551 1.231 EFFICIENCY OR ACTIVITY RATIOS Cash Return on Assets 0.016 0.001 Cash Return on Fixed Assets 0.053 0.008 Cash Reinvestment Ratio NA 1.389 Cash Turnover Ratio 9.957 7.661 Cash Balance or Days Cash Balance 36.658 47.0645 PROFITABILITY OR OPERATION RATIOS Earnings Quality -0.342 0.060 Cash Flow from Sales to Sales 0.028 0.002 Cash Flow Margins 0.028 0.002 COVERAGE OR LEVERAGE RATIOS Cash Flow to Lone Term Debt 0.121 0.010 Cash Dividend Ratio NA NA Cash Return to Shareholders 0.037 0.003 Cash Flow per- share 0.094 0.008 RATIOS 2006 2007 LIQUIDITY OR SOLVENCY RATIOS Operating Cash Flow Ratio 0.158 0.038 Cash Ratio 0.137 0.158 Cash Debt Coverage Ratio 0.129 0.030 Cash Interest Coverage 18.946 6.415 EFFICIENCY OR ACTIVITY RATIOS Cash Return on Assets 0.068 0.016 Cash Return on Fixed Assets 0.383 0.102 Cash Reinvestment Ratio -0.412 1.221 Cash Turnover Ratio 8.265 7.756 Cash Balance or Days Cash Balance 44.164 47.061 PROFITABILITY OR OPERATION RATIOS Earnings Quality 3.163 0.696 Cash Flow from Sales to Sales 0 104 0.023 Cash Flow Margins 0.104 0.023 COVERAGE OR LEVERAGE RATIOS Cash Flow to Lone Term Debt 0.696 0.151 Cash Dividend Ratio NA NA Cash Return to Shareholders 0.143 0.034 Cash Flow per- share 0.273 0.034

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Author: | Ibarra, Venus C. |
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Publication: | Journal of International Business Research |

Geographic Code: | 1USA |

Date: | Mar 1, 2009 |

Words: | 10236 |

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