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Developing ratios for effective cash flow statement analysis.

The statement of cash flows has been a required part of annual financial statements for more than two years. While there has been considerable support for this statement since its proposal in 1986, little has been written or developed on the effective use or analysis of it. This article provides suggested ratios that can be used by financial statement users to analyze and evaluate corporate cash flows.

Analysts have traditionally evaluated financial statements using financial ratios. Any text on corporate reporting or any analyst's report contains ratios comparing information from the balance sheet and income statement. These ratios are used for comparison with prior years, other companies or industry norms. To date, neither text writers nor analysts have developed ratios for effective evaluation of the statement of cash flows. Such ratios, used in conjunction with traditional balance sheet and income statement ratios, should lead to a better understanding of the financial strengths and weaknesses of the underlying entity.



The Financial Accounting Standards Board, which issued Statement no. 95, Statement of Cash Flows, in November 1987, describes the primary purpose of the cash flow statement as providing relevant information about an enterprise's cash receipts and payments during a particular period. The FASB suggests this statement be used by investors, creditors and others to assess

* An enterprise's ability to generate future positive net cash flows.

* An enterprise's ability to meet its obligations and pay dividends, and its needs for external financing.

* The reasons for differences between net income and associated cash receipts and payments.

* The effects on an enterprise's financial position of both its cash and noncash investing and financing transactions during the period.

If cash flow information is useful but unused, the logical conclusion is the business world is not analyzing available data properly. The solution is to develop tools that allow comparison of companies on a year-to-year basis and across companies. Although this article limits its approach for measuring performance to cash flow ratios, use of trend analysis and an evaluation of traditional accrual-based ratios are equally important in the analysis of financial statements.


The statement of cash flows requires cash flow disclosure by the functional areas of operating, investing and financing. While cash flows from investing and financing are important components, the most scrutinized figure is likely to be cash flow from operations. While this is a key figure, it is important to consider the impact of abnormal transactions such as those related to unusual events, discontinued operations or extraordinary items it may contain. When using ratios to predict future cash flows, the inclusion of such items obviously would distort continuing cash flows and could mislead potential investors. Similar problems exist if unusual one-time transactions are included in cash flows from operations.

The important point is that cash flow from operations, just like income from operations, can include a diverse mix of transactions representing a variety of unusual events. Analysis should include cash provided by normal operating activities only. This approach has been adopted when defining cash flow from operations in the ratios discussed below.



One objective of Statement no. 95 is the assessment of an enterprise's ability to meet its obligations and pay dividends. An analysis should determine whether the enterprise is able to generate enough cash to do this. Recommended cash flow ratios that analyze a company's ability to meet these obligations include cash interest coverage, cash debt coverage and cash dividend coverage. These ratios are illustrated in exhibit 1, page 67.

Cash interest coverage. The cash interest coverage ratio should complement the traditional interest coverage ratio. The ratio tells investors the number of times cash outflows for interest are covered by cash flows from operations. The ratio, when compared with the industry norm, indicates company liquidity and its ability to meet interest commitments. It also helps investors and creditors determine the extent to which cash flows could fall before the company risks default on its interest payments.

The traditional accrual-based interest coverage ratio uses income before interest and taxes divided by interest expense. Accrual-based income includes many non-cash-flow items, such as write-down of assets or gains on the sale of operating assets, and therefore may not clearly show a company's ability to meet actual interest payments. A better measure would be cash flows from operations before interest and taxes divided by interest payments.

Statement no. 95 makes the adjustment for interest and taxes easier by requiring separate disclosure of these cash flows. Unfortunately, this information may not be entirely accurate. Many companies have adopted the practice of showing cash flows for interest net of capitalized interest, which understates the true cash outflows associated with interest costs. It is essential, therefore, to evaluate the provided footnote disclosure figures carefully to determine whether additional adjustments should be made.

Cash debt coverage. A company's ability to continue as a going concern is dependent not only on meeting current interest payments but also on repayment of debt principal. Two measures used by bankers to determine an entity's ability to repay its debt are the ratio of retained operating cash flow to total debt and the ratio of retained operating cash flow to current maturities of debt. Retained operating cash flow measures the cash available for reinvestment that was generated by operations. It normally is defined as cash flow from operations less all dividend payments.

Both ratios indicate the time period required to free the company from its obligations using retained cash flows from operations to repay the debt. The first ratio takes total debt into consideration and thus shows the number of years current cash flows will be needed to meet this obligation. The second ratio indicates whether retained operating cash flow is sufficient to meet current maturities of long-term debt.

An alternative formulation of these two ratios could include existing cash and cash equivalents with retained operating cash flow. The argument here is these funds also are available to meet payment of debt. Additional modification of these ratios can include adding current liabilities or other fixed commitments such as lease obligations to the debt portion of the ratio.

Varying compositions of debt or liability commitments, or both, can result in a substantial number of ratios that measure the company's ability to meet future commitments. A consensus should be reached on which definition produces the most relevant ratio.

Cash dividend coverage. The cash dividend coverage ratio provides evidence of the ability to meet current dividends from normal operating cash flow. This ratio can evaluate a company's ability to pay all dividends or its ability to pay dividends to common stockholders. The ability of the company to pay all dividends is reflected by cash flow from operations divided by total dividend payments. To compute cash dividend coverage for common stockholders, dividends to preferred stockholders and minority stockholders in subsidiary companies are subtracted from cash flow from operations and the result is divided by cash payments to common stockholders.

Different approaches can be used to define dividend payments. The approach used is a function of whether dividend coverage is based on the ability to meet current dividends or future dividends. If the company has followed a policy of not regularly increasing dividends, it can use the cash paid for ordinary dividends as reported in the cash flow statement. Alternatively, if dividends are increasing constantly, the total dividends declared in the current year should be employed as a more up-to-date measure of prospective cash dividend requirements.


A second major reason cited in Statement no. 95 for requiring a statement of cash flows is it will assist users in determining reasons for differences between net income and associated cash receipts and payments. The reasons for these differences provide a basis for evaluating the quality of income. The measurement of cash flows is perceived as being more reliable and more objective than the measurement of income because the latter involves more judgment about accruals, allocations and valuations. Ratios that could be used to evaluate the quality of income are cash quality of sales and cash quality of income. These are illustrated in exhibit 2, below.

Quality of sales. Statement no. 95 strongly suggests the use of the direct method for disclosing cash flow information but allows companies to choose either the direct or indirect method. Current practice favors the indirect method.

An advantage of the direct method, which displays the individual cash flow impact of normal operating revenue and expense items, is it permits an evaluation of cash flows relating to specific line items in the income statement such as gross sales, cost of goods sold or even total operating expenses. An example of such a ratio would be the cash quality of sales shown in exhibit 2. While these measures will be available to those who have access to detailed information, they are not generally available to the external analyst, since few companies report cash flows using the direct approach. As a result, investors and creditors must make their judgments about the quality of income based on the indirect method.

Quality of income. The simple approach for evaluating the quality of income is a ratio comparing cash flows from operations to operating income. The quality of income ratio is intended to provide an indication of the variance between cash flows and reported earnings. Reported earnings, in many cases, include income, such as installment sales, or expenses, such as depreciation, which do not have a current cash impact. Such noncash transactions can result in substantial differences between cash flows and earnings, which are highlighted by abnormal deviations in the ratio over time.

A suggested alternative measure of the quality of income ratio is cash flow from operations before interest and taxes divided by income before interest, taxes and depreciation. This ratio eliminates major noncash items in the income statement (depreciation and deferred taxes) and should result in a closer approximation of cash to income from normal operations. Any major variances from a one-to-one ratio should automatically result in investigation of the abnormality.


A company's competitive advantage depends on its ability to maintain its capital assets. A company's cash-generating ability must be capable not only of meeting its obligations but also of financing capital expenditures. Analysts need to evaluate whether the company can meet these expenditures.

Statement no. 95 requires separate disclosure of cash expenditures for property, plant and equipment and cash inflows from their disposal. Information on total capital expenditures also is available from the segment disclosure requirements of FASB Statement no. 14, Financial Reporting for Segments of a Business Enterprise, and in the company's 10-K filing. Given such disclosure, ratios can be developed that indicate whether a company has the ability to finance its capital expenditures from internal sources. These ratios are shown in exhibit 3, below.

Capital acquisitions ratio. The capital acquisitions ratio shows a company's ability to meet its capital expenditure needs. This ratio is computed as retained operating cash flows divided by acquisitions. In this ratio, retained cash flows after dividend payments is used as the measure of cash available for capital expenditures. Even though dividends don't have to be paid, if they have been paid in the past there is an expectation they will continue. Therefore, dividends paid are deducted from cash flows from operations.

One practical problem in the calculation of capital expenditure ratios is defining capital expenditures. Capital expenditures could be limited to the replacement of property, plant and equipment for normal operations or could include acquisitions of additional operations or companies. Ultimately, all replacement and expansion expenditures must be financed by cash flows from earnings.

Another problem is what to do with capital disposals. They could be added to retained cash flows or offset against capital expenditures. An argument can reasonably be made that the disposal of capital assets is an attempt to maintain a satisfactory return. Proceeds are then invested in capital assets to achieve that return. These funds therefore should be included with cash flows from operations.

Major acquisitions commonly are acquired by financing, which will not have an immediate impact on cash outflows. As a result, cash flows for capital expenditures may vary substantially from year to year. Future cash outflows for these acquisitions will be reflected as repayment of debt, which are classified as financing activities. The full cash flow impact of the acquisition decision may never appear as part of investing activities. While a comparison of current cash outflows for capital acquisitions to cash generated by operations may give a short-term view of the adequacy of cash flows, it may be more useful to compare operating cash flows with average gross capital expenditures over a period of years.

Investment/finance ratio. The interrelationships between net operating, investing and financing cash flows can indicate how investments are being financed. The investment to finance ratio compares the total funds needed for investing purposes with funds generated from financing. Alternatively, cash flows for investment activities can be compared to cash flows from both financing and operating activities. Normally ratios such as these tend to fluctuate so much that meaningful results are obtained only be averaging figures over a period of years.


Cash flow ratios also can be developed that reflect returns on assets. The cash-generating efficiency of an enterprise is closely related to profitability and potential returns paid to investors. Historical cash flows may thus provide evidence of an entity's ability to generate future cash flows. Cash flow returns on investment can be computed in much the same way as accrual-based profitability measures. Suggested ratios, which are illustrated in exhibit 4, at right, can be returns per share, or returns on a level of invested capital.

While the cash return ratios shown in exhibit 4 are the counterpart of similar accrual-based profitability ratios, they should be used with caution. The cash flow ratios contain no provision for replacement of assets or for future commitments. This is in contrast to the profitability measures that contain provisions for depreciation and charges for such items as future pension liabilities. Ratios such as cash flow per share should not be used as indicators of potential cash distribution but should be used in conjunction with other profitability measures. The FASB prohibits reporting of cash flow per share information in financial statements. At the same time, it should be noted that cash flow per share is the cash flow ratio most frequently used by financial analysts.

Cash flow per share. Cash flow per share is defined as the cash available to common stockholders, or their equivalents, divided by the weighted average number of common shares outstanding. Cash flow per share, cautiously interpreted, can provide some information because it indicates the operating cash flow attributable to each common share. Investors can determine the cash payout ratio by comparing the cash dividend coverage ratio to cash flow per share. It provides comparison of the total cash available per share compared to cash distributed in dividends.

Return on investment. Perhaps more useful than the cash flow per share ratio are cash returns on investment. These can be computed as either a return on total assets, a return on debt and equity, or a return on stockholders' equity.

The cash return on total assets ratio (computed on a cash flow before taxes and interest basis) is equivalent to the return on total investment. Analysts traditionally have considered the return on investment ratio to be the key profitability ratio. The cash-generating ability of the assets also should be key in the evaluation of investments. Strong cash returns help generate future investments.

The cash return on invested capital computed either from the point of view of the total permanent investment made by both debt holders and stockholders or from the point of view of only stockholders indicates the ability of an entity to generate returns to the investor. The return to stockholders should be computed after deducting interest and other prior claims. The cash return to all permanent investors normally should be computed prior to the distributions paid to them, which implies use of a preinterest and pretax basis.

These cash return measures, taken over a period of time and compared to industry norms, provide guidance on the enterprise's ability to generate superior future cash flows from invested funds.


The incorporation of cash flow data into the analysis process has been slow in coming and is long overdue. Current literature has provided little help. Ratios such as those suggested here should help evaluate cash flows for business entities. While the use of these suggested ratios will provide further tools for the analysis of financial statements, there is a need to reach a consensus on some common ratios. Ratios in isolation are of little value until expected norms for companies and industries are developed.

CHARLES A. CARSLAW, CA, is an associate professor of accounting at the University of Nevada, Reno. An affiliate of the Nevada Society of CPAs, he holds memberships in the Institute of Chartered Accountants in England and Wales, the New Zealand Society of Accountants and the Canadian Institute of Chartered Accountants. JOHN R. MILLS, CPA, DBA, is an associate professor of accounting at the University of Nevada. He is a member of the American Institute of CPAs, the American Accounting Association and the Institute of Management Accountants (formerly the National Association of Accountants).
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Author:Mills, John R.
Publication:Journal of Accountancy
Date:Nov 1, 1991
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