The power of cash flow ratios.Many auditors spend less time with the cash flow statement than with the income statement and balance sheet. They shouldn't. To fully understand a company's viability as an ongoing concern, an auditor would do well to calculate a few simple ratios from data on the client's cash flow statement (the statement of sources and uses of cash). Without that data, he or she could end up in the worst possible position for an auditor--having given a clean opinion on a client's financials just before it goes belly up. When it comes to liquidity analysis, cash flow 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--for example, pension contributions and depreciation and amortization. In contrast, the cash flow statement records the changes in the other statements and nets out the bookkeeping bookkeeping, maintenance of systematic and convenient records of money transactions in order to show the condition of a business enterprise. The essential purpose of bookkeeping is to reveal the amounts and sources of the losses and profits for any given period. artifice ar·ti·fice n. 1. An artful or crafty expedient; a stratagem. See Synonyms at wile. 2. Subtle but base deception; trickery. 3. Cleverness or skill; ingenuity. , focusing on what shareholders really care about: cash available for operations and investments. For years, credit analysts and Wall Street barracudas have been using ratios to mine cash flow statements for practical revelations. The major credit-rating agencies use cash flow ratios prominently in their rating decisions. Bondholders--especially junk bond junk bond, a bond that involves greater than usual risk as an investment and pays a relatively high rate of interest, typically issued by a company lacking an established earnings history or having a questionable credit history. investors--and leveraged buyout leveraged buyout, the takeover of a company, financed by borrowed funds. Often, the target company's assets are used as security for the loans acquired to finance the purchase. specialists use free cash flow ratios to clarify the risk associated with their investments. That's because, over time, free cash flow ratios help people gauge a company's ability to withstand cyclical cyclical Of or relating to a variable, such as housing starts, car sales, or the price of a certain stock, that is subject to regular or irregular up-and-down movements. downturns or price wars. Is a major capital expenditure feasible in a tough year? If the last time total cash got a hair below where it is now the company's capital structure had to be revamped, the auditor should treat the deficient de·fi·cient adj. 1. Lacking an essential quality or element. 2. Inadequate in amount or degree; insufficient. deficient a state of being in deficit. value like a loud buzzer. Many auditors and, to a lesser extent, corporate financial managers have been slow to learn how to use cash flow ratios. In our experience, auditors traditionally use either a balance sheet or a transaction cycles approach. Neither approach emphasizes cash or the statement of cash flows. While auditors do use the cash flow statement to verify balance sheet and income statement accounts and to trace common items to the cash flow statement, their use of ratios for cash-related analysis has been limited to the current ratio (current assets/current liabilities) or the quick ratio (current assets Current Assets Appearing on a company's balance sheet, it represents cash, accounts receivable, inventory, marketable securities, prepaid expenses, and other assets that can be converted to cash within one year. less inventory/current liabilities). According to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. an informal survey of Big 5 and other national accounting firms, even now their audit procedures have not changed in ways that take advantage of the information presented in the cash flow statement, even though that statement has been required for over a decade. The value of cash flow ratios was evident in the collapse Of W. T. Grant. Traditional ratio analysis performed during the annual audit did not reveal the severe liquidity problems that resulted in a bankruptcy filing shortly thereafter. While W. T. Grant showed positive current ratios as well as positive earnings, in fact it had severely negative cash flows that rendered it unable to meet current debt and other commitments to creditors. Educators have not been emphasizing the cash flow statement either. Auditing textbooks commonly include only ratios based on the balance sheet and income statement with little or no discussion of cash ratios. The next generation of auditors needs to learn how to use cash flow ratios in audits because such measures are becoming increasingly important to the marketplace. Investors and others are relying on them. The cash flow ratios we find most useful fall into two general categories: ratios to test for solvency and liquidity and those that indicate the viability of a company as a going concern. In the first, liquidity indicators, the most useful ratios are operating cash flow Operating cash flow Earnings before depreciation minus taxes. Measures the cash generated from operations, not counting capital spending or working capital requirements. (OCF (1) (Open Container Format) See OPS. (2) (OpenCard Framework) A smart card specification from the OpenCard Consortium. ), funds flow coverage (FFC FFC Fleet Forces Command FFC Fédération Française de Cardiologie FFC Flexible Flat Cable FFC Financial and Fiscal Commission (South Africa) FFC Flat-Field Correction FFC Francis Ford Coppola (movie director) ), cash interest coverage (CIC CIC circulating immune complexes. CIC Circulating immune complexes. See Immune complexes. ) and cash debt coverage (CDC See Control Data, century date change and Back Orifice. CDC - Control Data Corporation ). In the second category, ratios used to assess a company's strength on an ongoing basis, we like total free cash (TFC TFC Traffic TFC Traffic (logging abbreviation) TFC Team Fortress Classic (game) TFC The Filipino Channel TFC Thin Film Composite (type of reverse osmosis membrane) ), cash flow adequacy (CFA (Computer Fraud and Abuse Act of 1986) Signed into law in 1986, the CFA was a significant step forward in criminalizing unauthorized access to computer systems and networks. The Act applies to "federal interest computers" that include any system used by the U.S. ), cash to capital expenditures and cash to total debt. Lenders, rating agencies and analysts use all of these. Auditors should know when and how to use them, too. HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS Creditors and lenders began using cash flow ratios because those ratios give more information about a company's ability to meet its payment commitments than do traditional balance sheet working capital ratios such as the current ratio or the quick ratio. When a loan officer evaluates the risk she is taking by lending to a particular company, her greatest concern is whether the company can pay the loan back, with interest, on time. Traditional working capital ratios indicate how much cash the company had available on a single date in the past. Cash flow ratios, on the other hand, test how much cash was generated over a period of time and compare that to near-term obligations, giving a dynamic picture of what resources the company can muster TO MUSTER, mar. law. By this term is understood to collect together and exhibit soldiers and their arms; it also signifies to employ recruits and put their names down in a book to enroll them. to meet its commitments. Operating cash flow (OCF) ratio. The numerator numerator the upper part of a fraction. numerator relationship see additive genetic relationship. numerator Epidemiology The upper part of a fraction of the OCF ratio consists of net cash provided by operating activities. This is the net figure provided by the cash flow statement after taking into consideration adjustments for noncash items and changes in working capital. The denominator denominator the bottom line of a fraction; the base population on which population rates such as birth and death rates are calculated. denominator is all current liabilities Current Liabilities Usually appearing on a company's balance sheet, it represents the amount owed for interest, accounts payable, short-term loans, expenses incurred but unpaid, and other debts due within one year. , taken from the balance sheet. Operating cash flow ratios Operating Cash Flow Ratio A measure of how well current liabilities are covered by the cash flow generated from a company's operations. Formula: vary radically, depending on the industry. For example, the gaming industry generates substantial operating cash flows due to the nature of its operations, while more capital-intensive industries, such as communications, generate substantially less. The gaming giant, Circus Circus Circus Circus is used as the name for two casinos:
Operating cash flow (OCF) Cash flow from operations Cash flow from operations A firm's net cash inflow resulting directly from its regular operations (disregarding extraordinary items such as the sale of fixed assets or transaction costs associated with issuing securities), calculated as the sum of net income plus noncash expenses / Current liabilities Company's ability to generate resources to meet current liabilities Funds flow coverage (FFC) ratio. The numerator of the FFC ratio consists of earnings before interest and taxes In financial and business accounting, earnings before interest and taxes (EBIT) is a measure of a firm's profitability that excludes interest and income tax expenses.[1] EBIT = Operating Revenue – Operating Expenses + Non-operating Income plus depreciation and amortization (EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) A metric used to show a company's profitability, but not its cash flow. EBITDA became popular in the 1980s to show the potential profitability of leveraged buyouts, but has become ), which differs from operating cash flow. Operating cash flow includes cash paid out for interest and taxes, which EBITDA does not. The FFC ratio highlights whether the company can generate enough cash to meet these commitments (interest and taxes). Accordingly, interest and taxes are excluded from the numerator. The denominator consists of interest plus tax-adjusted debt repayment plus tax-adjusted preferred dividends preferred dividend n. a payment of a corporation's profits to holders of preferred shares of stock. (See: preferred stock) . To adjust for taxes, divide by the complement of the tax rate. All of the figures in the denominator are unavoidable commitments. An auditor can use the FFC ratio as a tool to evaluate the risk that a company will default on its most immediate financial commitments: interest payments, short-term debt Short-term debt Debt obligations, recorded as current liabilities, requiring payment within the year. and preferred dividends (if any). If the FFC ratio is at least 1.0, the company can meet its commitments--but just barely. To survive in the long run, any company must have enough cash flow to maintain plant and equipment. To be really healthy, it should be able to reinvest re·in·vest tr.v. re·in·vest·ed, re·in·vest·ing, re·in·vests To invest (capital or earnings) again, especially to invest (income from securities or funds) in additional shares. cash for growth. Accordingly, if a company's FFC is less than 1.0, the company must raise additional funds to meet current operating commitments. To avoid bankruptcy, it must keep raising fresh capital. Funds flow coverage (FFC) EBITDA / (Interest + Tax-adjusted* debt repayment + Tax-adjusted(*) preferred-dividends) Coverage of unavoidable expenditures (*) To adjust for taxes, divide by the complement of the tax rate. Cash interest coverage ratio. The numerator of cash interest coverage consists of cash flow from operations, plus interest paid plus taxes paid. The denominator includes all interest paid--short term and long term. The resultant multiple indicates the company's ability to make the interest payments on its entire debt load. A highly leveraged company will have a low multiple, and a company with a strong balance sheet will have a high multiple. Any company with a cash interest multiple less than 1.0 runs an immediate risk of potential default. The company must raise cash externally to make its current interest payments. The cash interest coverage ratio is analogous analogous /anal·o·gous/ (ah-nal´ah-gus) resembling or similar in some respects, as in function or appearance, but not in origin or development. a·nal·o·gous adj. to the old-fashioned coverage ratio (also known as the interest coverage ratio). However, where the numerator of the coverage ratio begins with earnings from the income statement, the numerator of the cash interest coverage ratio begins with cash from the cash flow statement. Cash interest coverage gives a more realistic indication of the company's ability to make the required interest payments. Earnings figures include all manner of noncash charges--depreciation, pension contributions, some taxes and stock options. A company with a low income-based coverage ratio may actually be able to meet its payment obligations, but the mask of noncash charges Noncash charge A cost, such as depreciation, depletion, and amortization, that does not involve any cash outflow. That is, this is treated as an accounting expense -- not a real expense that demands cash. makes it difficult to see that. A cash-based coverage ratio gives a direct look at the cash available to pay interest. Cash interest coverage Cash flow from operations + Interest paid + Taxes paid / Interest paid Company's ability to meet interest payments Cash current debt coverage ratio. The numerator consists of retained operating cash flow--operating cash flow less cash dividends. The denominator is current debt--that is, debt maturing within one year. This is, again, a direct correlate of an earnings current debt coverage ratio, but more revealing because it addresses management's dividend distribution policy and its subsequent effect on cash available to meet current debt commitments. As with the cash interest coverage ratio, the current debt ratio indicates the company's ability to carry debt comfortably. The higher the multiple, the higher the comfort level. But like most other ratios, as long as the company is not insolvent INSOLVENT. This word has several meanings. It signifies a person whose estate is not sufficient to pay his debts. Civ. Code of Louisiana, art. 1980.. A person is also said to be insolvent, who is under a present inability to answer, in the ordinary course of business, the responsibility , the appropriate level varies by industry characteristics. Cash current debt coverage Operating cash flow - cash dividends / Current debt Company's ability to repay its current debt HOW TO USE CASH RATIOS AS A MEASURE OF FINANCIAL HEALTH Beyond questions of immediate corporate solvency, auditors need to measure a client's ability to meet ongoing financial and operational commitments and its ability to finance growth. How readily can the company repay or refinance Refinance 1. When a business or person revises their payment schedule for repaying debt. 2. Replacing an older loan with a new loan offering better terms. Notes: When a business refinances they typically extend the maturity date. its long-term debt Long-Term Debt Loans and financial obligations lasting over one year. Notes: For example debts obligations such as bonds and notes which have maturities greater than one year would be considered long-term debt. ? Will it be able to maintain or increase its current dividend to stockholders? How readily will it be able to raise new capital? Banks, credit-rating agencies and investment analysts understandably are very concerned with these questions. Accordingly, they have developed several ratios to provide answers to them. Auditors, who are more concerned about full disclosure, can use these same ratios to pinpoint areas for closer scrutiny when planning an audit. Capital expenditure ratio. The numerator is cash flow from operations. The denominator is capital expenditures. A financially strong company should be able to finance growth. This ratio measures the capital available for internal reinvestment Reinvestment Using dividends, interest and capital gains earned in an investment or mutual fund to purchase additional shares or units, rather than receiving the distributions in cash. 1. In terms of stocks, it is the reinvestment of dividends to purchase additional shares. and for payments on existing debt. When the capital expenditure ratio exceeds 1.0, the company has enough funds available to meet its capital investment, with some to spare to meet debt requirements. The higher the value, the more spare cash the company has to service and repay debt. As with all ratios, appropriate values vary by industry. Cyclical industries Cyclical Industry A term describing an industry that is sensitive to the business cycle and price changes. Many cyclical industries produce durable goods such as raw materials and heavy equipment. , such as housing and autos, may show more variation in this figure than noncyclical industries, such as pharmaceuticals and beverages. Also, a low figure is more understandable in a growth industry, such as technology, than in a mature industry, such as textiles. Capital expenditure Cash flow from operations / Capital expenditures Company's ability to cover debt after maintenance or investment on plant and equipment Total debt (cash flow to total debt) ratio. The numerator is cash flow from operations. The denominator is total debt--both long term and short term. Total cash flow to debt is of direct concern to credit-rating agencies and loan decision officers. This ratio indicates the length of time it will take to repay the debt, assuming all cash flow from operations is devoted to debt repayment. The lower the ratio, the less financial flexibility the company has and the more likely that problems can arise in the future. Auditors should take diminished financial flexibility into account when identifying high-risk audit areas during planning. Total debt Cash flow from operations / Total debt Company's ability to cover future debt obligations NET FREE CASH FLOW RATIOS Other ratios that spotlight a company's viability as a going concern rely on a computation Computation is a general term for any type of information processing that can be represented mathematically. This includes phenomena ranging from simple calculations to human thinking. of net free cash flow. Net free cash flow (NFCF NFCF Near Field Communications Forum ) is not yet well defined, although bankers are working to standardize stan·dard·ize v. 1. To cause to conform to a standard. 2. To evaluate by comparing with a standard. these computations in a way that would facilitate comparisons across companies and across industries. However, at present, there are still many variations of net free cash flow. We propose a total free cash (TFC) ratio developed by First Interstate in·ter·state adj. Involving, existing between, or connecting two or more states. n. One of a system of highways extending between the major cities of the 48 contiguous United States. Noun 1. Bank of Nevada, which uses it to make loan decisions and loan covenant A loan covenant is a condition in a commercial loan or bond issue that requires the borrower to fulfill certain conditions or forbids the borrower from undertaking certain actions, or possibly restricts certain activities to circumstances when other conditions are met. agreements. This TFC computation offers the advantage of incorporating the effects of off-balance-sheet financing--by taking into account operating lease Operating Lease A lease contract that allows the use of an asset, but does not convey rights similar to ownership of the asset. Notes: An operating lease is not capitalized it is accounted for as a rental expense. and rental payments. TFC ratio. The numerator of this ratio is the sum of net income, accrued ac·crue v. ac·crued, ac·cru·ing, ac·crues v.intr. 1. To come to one as a gain, addition, or increment: interest accruing in my savings account. 2. and capitalized interest Capitalized interest Interest that is not immediately expensed, but rather is considered as an asset and is then amortized through the income statement over time. In the context of project financing, interest that is paid by additional borrowing. expense, depreciation and amortization and operating lease and rental expense less declared dividends declared dividend A dividend authorized by a firm's board of directors. At the time a dividend is declared, the firm creates a liability for the dividend's payment. and capital expenditures. The denominator is the sum of accrued and capitalized interest expense, operating lease and rental expense, the current portion of long-term debt Current Portion Of Long-Term Debt A portion of the balance sheet that represents the total amount of long-term debt that must be paid within the next year. The balance sheet has a liability section, which is broken down into long-term and current debt. and the current portion of long-term lease obligations. Varying definitions of capital expenditures can confuse con·fuse v. con·fused, con·fus·ing, con·fus·es v.tr. 1. a. To cause to be unable to think with clarity or act with intelligence or understanding; throw off. b. the issue. Since different definitions change the value of free cash flow ratios, it is best to be clear about which definition the auditor is using and why it makes sense for a particular purpose. Total free cash (TFC)([dagger]) (Net income + Accrued and capitalized interest expense + Depreciation and amortization + Operating lease and rental expense - Declared dividends - Capital expenditures) / (Accrued and capitalized interest expense + Operating lease and rental expense + Current portion of long-term debt + Current portion of capitalized lease obligations) Company's ability to meet future cash commitments ([dagger]) These ratios require computation of the company's net free cash flows. As net free cash flow can vary by company as well as by industry, the formulas should be considered as recommended rather than absolute. For example, if the auditor is trying to determine whether the company can maintain its present level of operations, the capital spending capital spending Spending for long-term assets such as factories, equipment, machinery, and buildings that permits the production of more goods and services in future years. figure used should exclude new investments and be limited to the amount of spending required to maintain operating assets Operating Assets Another term for working capital. . Sometimes maintenance spending is estimated at 2% of total assets, or up to 5% of property, plant and equipment. Industries with very long-lived capital assets capital assets n. equipment, property, and funds owned by a business. (See: capital, capital account) may use smaller percent-ages to estimate maintenance spending. However, if the auditor is more interested in long-term growth potential, then actual capital expenditures from the cash flow statement should be used. Cash flow adequacy (CFA) ratio. The numerator is earnings before interest, taxes, depreciation and amoritzation (EBITDA) less taxes paid (cash taxes) less interest paid (cash interest) less capital expenditures (as qualified above). The denominator is the average of the annual debt maturities scheduled over the next five years. Cash flow adequacy helps smooth out some of the cyclical factors that pose problems with the capital expenditure ratio. It also makes allowances for the effects of a balloon payment The final installment of a loan to be paid in an amount that is disproportionately larger than the regular installment. When a loan is made, repayment of the principal, which is the amount of the loan, plus the interest that is owed on it, is divided into installments due at . Companies with strong NFCF compared with upcoming debt obligations are better credit risks than companies that must use outside capital sources. Thus, a high CFA means high credit quality. Cash flow adequacy (CFA)([dagger]) (EBITDA - taxes paid - interest paid - capital expenditures) / (Average annual debt maturities scheduled over next 5 years) Company's credit quality ([dagger]) These ratios require computation of the company's net free cash flows. As net free cash flow can vary by company as well as by industry, the formulas should be considered as recommended rather than absolute. KNOW YOUR CLIENT In order to fully understand where to set the levels at which the cash flow ratios discussed here should trigger deeper investigation, auditors need to understand their clients' businesses and the industries in which they operate. As with any other ratio, an auditor should listen to the client's explanation of any unfavorable changes in cash ratios before becoming too alarmed. An auditor should know what cash concerns are critical to a company's business. We wouldn't suggest that a successful audit is just a matter of picking the right equations and plugging in the numbers. There are no absolutes. But properly applied, cash flow ratios can be revealing to auditors during the audit planning stages and can give the auditor a more accurate picture of the company. Auditors must ascertain whether the financial statements are fairly presented in accordance with GAAP GAAP See: Generally Accepted Accounting Principles GAAP See generally accepted accounting principles (GAAP). . They must be satisfied with the accuracy of the transactions and balances summarized in the four financial statements and the related disclosures. Effective auditors can use cash flow ratios to improve their understanding of the cash concerns critical to the particular company and to plan the audit more effectively.
Exhibit 1: Cash Flow Ratios Revealing Liquidity
Boomtown and Circus Circus: 1992 to 1996(*)
1992 1993 1994
Total assets (millions)
Boomtown $55.9 $108.6 $238.5
Circus Circus $783.1 $950.5 $1,297.9
LIQUIDITY ANALYSIS
Current
Boomtown 1.29 4.84 0.93
Circus Circus 1.14 0.90 0.95
Quick
Boomtown 0.92 4.21 0.50
Circus Circus 0.64 0.54 0.52
Cash interest
Boomtown 3.89 8.93 1.14
Circus Circus 5.26 7.08 7.49
OCF
Boomtown 1.20 1.54 -0.16
Circus Circus 2.82 1.96 2.03
FFC
Boomtown 1.00 0.16 -0.05
Circus Circus 3.22 1.35 5.00
Cash current debt
Boomtown 9.94 694.88 -0.08
Circus Circus 178.26 1,115.18 1,107.59
1995 1996
Total assets (millions)
Boomtown $239.2 $206.0
Circus Circus $1,507.1 $2,211.9
LIQUIDITY ANALYSIS
Current
Boomtown 1.36 1.36
Circus Circus 1.29 1.32
Quick
Boomtown 0.93 0.96
Circus Circus 0.76 0.82
Cash interest
Boomtown 1.76 1.87
Circus Circus 7.43 6.07
OCF
Boomtown 0.40 0.42
Circus Circus 3.04 2.60
FFC
Boomtown 1.12 -0.83
Circus Circus 7.19 4.33
Cash current debt
Boomtown 3.37 2.26
Circus Circus 2,350.70 283.35
(*) Boomtown boom·town n. A town experiencing an economic or a population boom. figures are on a September 30 fiscal year; Circus Circus' are on a January 31 year. Source: Company financial statements and calculations by the authors.
Exhibit 2: Cash Flow Ratios Reveling Ongoing Viability
Boomtown and Circus Circus: 1992 to 1996(1)
1992 1993 1994
Total assets (millions)
Boomtown $55.9 $108.6 $238.5
Circus Circus $783.1 $950.5 $1,297.9
GOING-CONCERN ANALYSIS
Debt to equity
Boomtown 2.83 0.04 1.21
Circus Circus 1.22 0.81 1.18
Times interest earned
Boomtown 2.11 7.02 -0.95
Circus Circus 4.31 5.86 5.57
TFC(2) (actual(3))
Boomtown 0.77 -8.44 -5.77
Circus Circus 3.55 -0.26 -4.13
TFC(2) (maintenance(3))
Boomtown 1.91 4.85 0.48
Circus Circus 3.77 5.27 4.75
Total debt
Boomtown 0.18 1.54 0.00
Circus Circus 0.42 0.43 0.28
CFA (actual(3))
Boomtown -0.60 N/A(4) -91.88
Circus Circus 9.36 1.97 -0.67
CFA (maintenance(3))
Boomtown 0.95 N/A(4) -9.57
Circus Circus 4.43 2.43 2.88
Capital expenditures (actual(3))
Boomtown 1.08 0.28 0.00
Circus Circus 6.31 82 0.49
Capital expenditures
(maintenance(3))
Boomtown 6.13 302 -0.04
Circus Circus 10.71 9.03 7.21
1995 1996
Total assets (millions)
Boomtown $239.2 $206.0
Circus Circus $1,507.1 $2,211.9
GOING-CONCERN ANALYSIS
Debt to equity
Boomtown 1.25 1.86
Circus Circus 1.04 0.66
Times interest earned
Boomtown 0.51 -1.83
Circus Circus 5.46 4.24
TFC(2) (actual(3))
Boomtown 0.68 0.08
Circus Circus 2.51 1.00
TFC(2) (maintenance(3))
Boomtown 0.99 0.12
Circus Circus 4.74 3.76
Total debt
Boomtown 0.08 0.09
Circus Circus 0.35 0.30
CFA (actual(3))
Boomtown -7.14 -22.57
Circus Circus 4.44 2.90
CFA (maintenance(3))
Boomtown -1.15 -21.56
Circus Circus 2.99 2.65
Capital expenditures (actual(3))
Boomtown 0.66 2.00
Circus Circus 1.75 1.10
Capital expenditures
(maintenance(3))
Boomtown 2.08 2.76
Circus Circus 8.27 5.53
(1) Boomtown figures are on a September 30 fiscal year; Circus Circus' are on a January 31 year. (2) TFC has been calculated using single-year cash flow rather than a three-year average. Averaging was not considered appropriate because of the growth rate. (3) These ratios can be calculated using either actual capital expenditures or an estimate of the amount required for ordinary replacement and maintenance (estimated at 2% of total assets). (4) NA--Boomtown had no long-term debt in 1993. Source: Company financial statements and calculations by the authors. RELATED ARTICLE: CASE STUDY Running a Casino Is Not a Game The gaming industry expanded to 12 states from 2 between 1989 and 1995. During that time, many of the traditional casino corporations managed asset growth rates Growth Rates The compounded annualized rate of growth of a company's revenues, earnings, dividends, or other figures. Notes: Remember, historically high growth rates don't always mean a high rate of growth looking into the future. of 200% and more. Rapid expansion led to major problems, including bankruptcy, when revenues did not meet projections. As this examination of two gaming companies shows, cash flow analysis can help avoid business meltdowns, providing auditors and clients with an additional level of comfort in both planning the audit and evaluating the strength of the going concern. Boomtown was a relatively young but successful Nevada company that went public in October 1992, with assets of $56 million. By 1995, its assets were up to $239 million, dropping to $206 million in 1996. Company operations grew from one casino in the local Nevada market to four properties in three states--Nevada, Louisiana and Mississippi. In the same period, Circus Circus was one of the largest and most profitable gaming corporations in the industry. Its properties, also all in Nevada at that time, included the Excalibur and the original Circus Circus in Las Vegas Las Vegas (läs vā`gəs), city (1990 pop. 258,295), seat of Clark co., S Nev.; inc. 1911. It is the largest city in Nevada and the center of one of the fastest-growing urban areas in the United States. , the Colorado Bell and Edgewater in Laughlin and the Circus Circus in Reno. The company grew from total assets of $783 million in 1992 to over $2.2 billion by 1996, including acquisitions. By the end of 1996, it had operations in three states--Nevada, Louisiana and Mississippi. Liquidity Assessment Exhibit 1, page 60, shows a variety of ratios calculated from the financial statements of Boomtown and Circus Circus. The figures cover the period from 1992 to 1996, although Circus Circus was on a January 31 fiscal year while Boomtown used a fiscal year ending September 30. Look at the lines for the current ratio (current assets/ current liabilities) and the quick ratio (current assets less inventories/current liabilities) for each. Viewed through the lens of these traditional balance-sheet-based ratios, Boomtown appears to be stronger financially than Circus Circus. But this was not the case. Boomtown's current ratio was frequently well over 1.00, even soaring to 4.84 in 1993, while Circus Circus' current ratio never strayed over 1.32. Boomtown was able to maintain a higher quick ratio as well. Over the five years in question, Boomtown's current ratio showed fairly consistent improvement, a trend that would be reassuring re·as·sure tr.v. re·as·sured, re·as·sur·ing, re·as·sures 1. To restore confidence to. 2. To assure again. 3. To reinsure. to most auditors. Although the balance sheet ratios for both companies are fairly low, that is normal for the gaming industry. Casinos just don't carry much inventory--mostly perishable per·ish·a·ble adj. Subject to decay, spoilage, or destruction. n. Something, especially foodstuff, subject to decay or spoilage. Often used in the plural. foods and the like. And gaming companies carry practically no receivables because gaming generally is a cash business. The traditional measures don't address operating cash flows or cash interest coverage directly, but auditors can use cash flow ratios to answer questions about their clients' liquidity--Are these companies generating enough cash to cover their current liabilities? How many times does cash flow from operations cover interest expense? Boomtown's cash interest coverage was considerably weaker than that of Circus Circus, except in 1993, when Boomtown had no long-term debt. Circus Circus consistently maintained cash in excess of 5 times debt. Now look at the line for OCE See AOCE. Over the interval shown, the Circus Circus OCF ratio slipped under 2.00 only once, meaning that it generated enough cash to cover its current liabilities twice over--and even improved on that despite a rapid growth rate. The company's cash interest coverage ratio also was consistently high. Boomtown's cash flow ratios, however, might surprise an auditor relying solely on balance sheet ratios. Its OCF was consistently weaker than that of Circus Circus, even slipping into a negative position in 1994. Once Boomtown's OCF slipped below 1.00, it was not generating enough cash to meet its current commitments. Accordingly, it had to find other sources for financing normal operations Generally and collectively, the broad functions that a combatant commander undertakes when assigned responsibility for a given geographic or functional area. Except as otherwise qualified in certain unified command plan paragraphs that relate to particular commands, "normal operations" of . An auditor relying solely on the quick and current ratios in this instance would have missed that important point. An auditor who bothered to calculate two other cash flow ratios--FFC and cash/current debt--would have gotten even more remarkable results. Because Circus Circus carried very little current debt, its cash covered current debt well over 175 times in every year, while Boomtown's cash didn't even cover current debt in 1994, and its cash/current debt coverage was in the single digits for three of the other four years. More remarkably, Boomtown's FFC went negative in 1994 and again in 1996 and was consistently weaker than that of Circus Circus in every year. Accordingly, the conclusions an auditor might draw after looking at the cash flow ratios might differ sharply from his or her opinion based solely on balance sheet ratios. Going-Concern Analysis Traditionally, auditors have used the balance-sheet-based debt-to-equity ratio debt-to-equity ratio The relationship between long-term funds provided by creditors and funds provided by owners. A firm's debt-to-equity ratio is calculated by dividing long-term debt by owners' equity. Both items are shown on the balance sheet. (total debt/total equity) and the times-interest-earned (EBIT/annual interest payments) ratio to examine a company's longer-term financial health (see exhibit 2, page 61). These measures do provide one perspective on the company's ability to carry its long-term debt obligations and its solvency. The traditional solvency ratios Solvency Ratio One of many ratios used to gauge a company's ability to meet long-term obligations. Notes: Derived by taking a company's net worth and dividing by total assets. See also: Asset, Asset Valuation, Balance Sheet, Fundamental Analysis, Income Statement reveal big differences between Circus Circus and Boomtown. Although both companies expanded considerably in 1993 and 1994, the effects on each corporation's financial position were drastically different. Circus Circus showed a downward trend in its traditional debt-to-equity ratio, an indicator of an increasingly strong balance sheet, while maintaining a fairly stable times-interest-earned ratio Times-interest-earned ratio Earnings before interest and tax, divided by interest payments. . After 1992, Boomtown's debt-to-equity ratio rose steadily, showing increasing reliance on outside borrowing. Its times-interest-earned ratio also weakened weak·en tr. & intr.v. weak·ened, weak·en·ing, weak·ens To make or become weak or weaker. weak  en·er n. , even going negative
twice.Cash flow ratios, however, provide an even clearer picture of each company's financial solvency. Consider the lines for TFC, two for each company--one based on actual capital expenditures and the other on estimated maintenance spending. Negative figures in 1993 reveal that Circus Circus needed to go outside to raise cash for capital expenditures in both 1993 and 1994. However, using a capital maintenance approach, figures consistently greater than 1.0 show the company was clearly generating enough cash flow from operations to maintain its normal operations and to provide at least some funds for additional growth. But 1993 and 1994 were years when total assets grew at 21% and 37%. Few companies could expand at this rate solely with internally generated funds from operations Funds From Operations (FFO) Used by real estate and other investment trusts to define the cash flow from trust operations; earnings with depreciation and amortization added back. . Analysis of Boomtown's cash flow ratios unveils a very different kind of growth. Its TFC (maintenance) ratio slipped below 1.0 for three years in a row. An auditor who notices that Boomtown wasn't able to fund normal operations from internal sources for three consecutive years has heard an alarm; however, the noise from the TFC (actual) ratio is even louder. Boomtown did not manage any of its growth from internally generated cash--its TFC (actual) ratio never got above 1.00! That can't go on forever. Now look at the total debt ratio line and the two cash flow adequacy (CFA) ratio lines for each company. The total debt ratio, to which credit-rating agencies and loan officers pay close attention, was quite stable for Circus Circus throughout. Boomtown's, which started out weaker, took one wild fluctuation Fluctuation A price or interest rate change. way up and then collapsed. Looking at the CFA ratios, once again Circus Circus exhibits more than adequate funds for maintenance and sufficient internally generated cash for new capital investments in all but one year. The one exception was attributable to rapid growth. Boomtown's spectacularly negative ratios shout the company's need for substantial outside funding. Turning to the capital expenditures ratio lines, Boomtown was unable to generate enough cash internally to even maintain plant and equipment in 1994, despite more than doubling its total assets. Circus Circus, on the other hand, had plenty of cash for maintenance throughout and needed outside cash to fund growth only for a two-year interval. In fact, Boomtown's cash ratios do indeed reveal that drastic changes would have been needed for this company to survive on its own. It didn't. Boomtown was acquired by Hollywood Park Hollywood Park may be several places:
The excess of operating expenses over revenue. As with operating income, operating losses exclude revenues and expenses from operations that are not considered a regular part of the business. Also called deficit. Compare operating income. . Despite its earlier promise, Boomtown ran out of cash. Traditional ratios would not have provided sufficient warning, but cash flow ratios would have. Auditors who employ cash flow ratios to assess corporate liquidity and viability can help their clients spot trouble in time to take corrective action A corrective action is a change implemented to address a weakness identified in a management system. Normally corrective actions are instigated in response to a customer complaint, abnormal levels if internal nonconformity, nonconformities identified during an internal audit or . RELATED ARTICLE: EXECUTIVE SUMMARY * CASH FLOW RATIOS ARE MORE RELIABLE indicators of liquidity than balance sheet or income statement ratios such as the quick ratio or the current ratio. * LENDERS, RATING AGENCIES AND WALL STREET analysts have long used cash flow ratios to evaluate risk, but auditors have been slow to use them. * SOME CASH FLOW RATIOS COMPARE THE RESOURCES A company can muster with its short-term commitments. * OTHER CASH FLOW RATIOS MEASURE A COMPANY'S ability to meet ongoing financial and operational commitments. * THERE IS NO CONSENSUS ON THE DEFINITION OF NET free cash flow, although the authors suggest taking off-balance-sheet financing Off-Balance-Sheet Financing A way of raising money that does not appear on the balance sheet. Notes: This is unlike loans, debt and equity, which do appear on the balance sheet. into account. * AUDITORS CAN USE THE INSIGHTS uncovered by cash flow ratios to spotlight potential problem areas, thus helping them plan their audits more effectively. JOHN R. MILLS, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , PhD, is a professor in the Department of Accounting and CIS Cis (sĭs), same as Kish (1.) (1) (CompuServe Information Service) See CompuServe. (2) (Card Information S at the University of Nevada, Reno The University of Nevada, Reno (Nevada or UNR) is a university located in Reno, Nevada, USA, and is known for its programs in agricultural research, animal biotechnology, and mining-related engineering and natural sciences. . His email address See Internet address. is www.mills@scs.unr.edu. JEANNE H. YAMAMURA, CPA, PhD, is an assistant professor in the accounting and CIS department at the university's Reno campus. Her e-mail address See Internet address. e-mail address - electronic mail address is www.yamamura@unr.edu. Mills' experience includes auditing and consulting in the gaming industry. Yamamura worked as an auditor overseas, including a stint in Papua, New Guinea New Guinea (gĭn`ē), island, c.342,000 sq mi (885,780 sq km), SW Pacific, N of Australia; the world's second largest island after Greenland. . |
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