Cash flows: another approach to ratio analysis.

Cash-flow-based ratios are useful in evaluating a company's financial strength and profitability.

One product of accounting evolution in the United States is the use of ratios for analyzing financial statements. Originally developed as short-term credit analysis devices, ratios can be traced as far back as the late 19th century. Since then, analysts have developed many financial ratios that are widely used by practitioners and academicians.

A relatively recent development has been the Financial Accounting Standards Board requirement to prepare a statement of cash flows. To date, little has been done to suggest a comprehensive set of cash flow ratios with the potential to evaluate financial performance. Scattered empirical evidence in published studies does not identify a complete set of useful ratios.

Relative performance evaluation is one important use of cash flow ratios, which can be viewed in terms of sufficiency and efficiency. Sufficiency describes the adequacy of cash flows for meeting a company's needs; efficiency describes how well a company generates cash flows relative both to other years and to other companies.

This article proposes some cash-flow-based ratios that can be used for relative performance evaluation. We conducted an empirical study of cash flow statements to provide some industry averages and to determine if the potential exists to develop benchmarks for the ratios by industry. These benchmarks can play an important part in evaluating the relative sufficiency and efficiency of a company's cash flows.

USE OF RATIOS

Analysts use ratios to predict financial variables and to evaluate relative performance. They group ratios into liquidity and profitability categories to predict bankruptcy, the probability of loan defaults and stock prices. Relative performance evaluation assumes comparing a company's performance to that of a chosen industry or benchmark ratio filters out the performance effects of common uncertainties, leaving only company-specific performance. In such evaluations, other companies' performance provides information about a specific company's performance.

Although recent studies yielded apparently contradictory results, most cash flow studies show the value of cash flow data. This is especially true in predicting bankruptcy and financial distress. Little has been done with respect to using cash flow ratios for relative performance evaluation.

CASH FLOW RATIOS

Our study provides a starting point for developing some benchmarks (norms or standards) for cash flow ratios. The cash flows from the operating activities classification on the statement of cash flows generally summarize the cash effects of transactions and other events involved in determining net income. Operating activities involve an enterprise's primary activities - the production and delivery of goods and services. They are the enterprise's primary focus and the primary variable of interest in this study. Cash from operations is a component of each of the ratios shown in exhibit 1, page 57, which have been classified as sufficiency or efficiency to describe their potential use in relative performance evaluation.

Sufficiency ratios. The cash flow adequacy ratio directly measures a company's ability to generate cash sufficient to pay its debts, reinvest in its operations and make distributions (dividends) to owners. A value of 1 over a period of several years shows satisfactory ability to cover these primary cash requirements. The long-term debt payment, dividend payout and reinvestment ratios provide further insight for investors and creditors into the individual importance of these three components. When expressed as percentages and added together, these three ratios show the percentage of cash from operations available for discretionary uses.

Although a company could use cash generated from financing and investing activities to retire debt, cash from operations represents the main source of long-term funds. The debt coverage ratio can be viewed as a payback period; that is, it estimates how many years, at the current level of cash from operations, it will take to retire all debt.

The depreciation-amortization impact ratio shows the percentage of cash from operations resulting from add-backs of depreciation and amortization. Comparing this ratio to the reinvestment ratio provides insight into the sufficiency of a company's reinvestment and the maintenance of its asset base.

Over several years, the reinvestment ratio should exceed the depreciation-amortization impact ratio to ensure sufficient replacement of assets at higher current costs. This ratio also can be used as an efficiency evaluation. A company would be considered more efficient if depreciation and amortization have a relatively low impact on cash from operations.

Efficiency ratios. Investors, creditors and others concerned with a company's cash flows are especially interested in the income statement and earnings measures. The cash flow to sales ratio shows the percentage of each sales dollar realized as cash from operations. Over time, this ratio should approximate the company's return on sales. The operations index compares cash from operations to income from continuing operations. It measures the cash-generating productivity of continuing operations. Cash flow return on assets is a measure of the return on assets used to compare companies on the basis of cash generation (as opposed to income generation) from assets.

Sufficiency and efficiency ratios are examples of information available to financial statement users from the cash flow statement. It's important to remember that, as in all ratio analysis, isolated ratios provide limited information about a single period. The ratios become more useful when computed for a period of years to determine averages and trends and when compared to industry averages.

STUDY RESULTS

Because they have the largest number of companies among the Fortune 500, we selected the electronics, food and chemical industries for our study. In 1988, these industries respectively ranked third, fourth and fifth in sales and third, fourth and sixth in assets among the Fortune 500. All companies in each industry were asked to provide their 1988 annual reports. Exhibit 2, page 57, shows an industry breakdown of the 99 companies that responded.

Each respondent included a statement of cash flows complying with FASB Statement no. 95, Statement of Cash Flows. Cash flow ratios were computed for 1986 through 1988 using the data from the annual reports. Exhibit 3, page 58, shows the three-year averages for each ratio by industry.

DATA ANALYSIS

The cash flow adequacy ratio depicts the extent a company's cash from operations covers payments on long-term debt, purchases of assets and dividend payments. A value of 1 might be considered a reasonable target. Based on mean values, none of the industries generated sufficient cash from operations to cover its primary cash requirements. The percentages of companies that had the cash to meet the target were electronics, 45%; food, 28%; and chemicals, 31%.

From 1986 through 1988, cash flow adequacy declined in the electronics and chemical industries but increased in the food industry. Electronics showed a large decrease (.91 to .80) in 1988 and food showed a large increase (.82 to.95), while chemicals showed a decline of 2 percentage points per year.

For the three-year period, less than half the companies had sufficient cash flow from operations to cover primary cash requirements. Three-year averages varied from .85 (food) to .89 (electronics); no significant differences between industries were found for the cash flow adequacy ratio.

Since each represents a major component of the denominator in the cash flow adequacy ratio, the long-term debt payment, dividend payout and reinvestment ratios are discussed by industry. For the electronics industry, the data showed increased reinvestment in assets and dividends paid relative to cash from operations and a decrease in debt retirement from 1986 to 1988. For 1988, asset reinvestment exceeded cash from operations.

From 1986 through 1988, food companies showed increases for long-term debt payments, dividends and reinvestment in assets. Relative to electronics, food and chemical companies spent a greater portion of cash from operations on long-term debt retirement. All three industries showed a tendency toward increased asset reinvestment during the period. Two industries (electronics and chemicals) showed decreases in the portion of cash from operations devoted to debt retirement.

Dividend payout showed consistency between years and between industries, approximating 20% of cash from operations over the three-year period for all three industries combined and showed stability from year to year. Debt coverage indicates the number of years required for cash from operations to repay all debt. Electronics companies showed a large increase in debt coverage (from 4.07 to 10.18) in 1988, due to declining payments on long-term debt and increased debt. Food and chemicals companies reflected more stable debt coverage, with three-year averages of 6.06 and 5.62, respectively.

For the depreciation-amortization impact ratio, the three industries showed different patterns over the period. The electronics and chemicals industries had relatively stable ratios, while food companies showed a large increase in 1988.

Reinvestment ratios suggested companies were reinvesting at a rate greater than they were depreciating assets. If companies are to maintain or increase their assets, over a several-year period reinvestment should exceed the depreciation-amortization impact ratio. Except for the food industry, reinvestments were, on average, sufficient to cover depreciation and amortization.

Cash flow to sales is a cash-flow-based measure of return on sales. Chemical companies showed the highest three-year average cash flow return, 12%, while electronics and foods showed 9% and 6%, respectively. These differences are significant between food and chemicals for all three years, between food and electronics in 1987 and between chemicals and electronics in 1988. Since food companies earn lower accounting returns on sales than do chemicals and electronics, these results are not surprising.

When compared to accrual income from continuing operations, the cash flow from operations ratio also is useful. It reflects the extent noncash transactions are involved in the operating income computation. Over several years, cash flow from continuing operations might be expected to approximate income from continuing operations. The operations index makes this comparison. For each industry, cash from operations exceeded income from continuing operations.

Cash flow return on assets compares cash from operations to total assets. For electronics companies, the return decreased by three points from 1986 to 1988. In part, this may be explained by the large increase in the reinvestment ratio. For food and chemical companies, the cash flow returns were stable. Comparing this ratio and the annuity return on assets may provide useful information.

USEFUL RATIOS

This article proposes nine cash-flow-based ratios for relative performance evaluation. These sufficiency and efficiency ratios provide additional information (over traditional financial ratios) about the relationship between cash flow from operations and other important operating variables. Averages for those ratios for companies in the three largest industrial groups in the Fortune 500 were computed for 1986 to 1988.

Only the cash flow to sales ratio showed significant differences between industries for all three years. The only other difference between industries occurred in 1988 for the operations index and the cash flow return on assets. In those instances benchmarks or cutoff values may be advisable by industry. For all other ratios, the results suggest common interindustry averages might be appropriate. While this study has provided new information about the potential value of cash-flow-based ratios, there is unlimited potential for additional research.

EXECUTIVE SUMMARY

* CASH FLOW RATIOS CAN help evaluate a company's financial performance in terms of both strength and profitability.

* SUFFICIENCY RATIOS evaluate the adequacy of cash flows for meeting a company's needs. Efficiency ratios evaluate how well the company generates cash flows relative to other years and other companies.

* CASH FLOW DATA CAN be particularly helpful in predicting bankruptcy and financial distress. Ratios are most useful when computed over a period of years to determine averages and trends.

* DEVELOPING BENCHMARKS for cash flow ratios in a particular industry may make the ratios more meaningful, enabling a company to compare its performance to that of similar companies.

* A STUDY OF COMPANIES in the electronics, food and chemical industries has yielded some useful ratios for evaluating cash flow adequacy, long-term debt payment, dividend payout, reinvestment, debt coverage and the impact of depreciation-amortization. Information on the ratio of cash flow to sales, the operations index and the cash flow return on assets also can be helpful.

DON E. GIACOMINO, CPA, DBA, is associate professor and chairman, Department of Accounting, Marquette University, Milwaukee, Wisconsin. He is a member of the Wisconsin Society of CPAs and the American Accounting Association. DAVID E. MIELKE, PhD, is associate professor of accounting, Marquette University. He is a member of the AAA.