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Go with the flow: using ratios to analyze cash flow data.

The Financial Accounting Standards Board (FASB) requires most companies to present a Statement of Cash Flows as part of their financial disclosures. Statement of Financial Accounting Standard (SFAS) No. 95, which became effective in 1988, requires most companies to disclose the changes in "cash or cash equivalents;" hence, most firms have issued several annual reports containing a statement of cash flows.

According to the Board, the primary purpose of the statement of cash flows is to provide relevant information regarding an entity's cash receipts and payments. SFAS No. 95 states, "The information provided in a statement of cash flows, if used with related disclosures and information in other financial statements, should help investors, creditors and others to:

(a) assess the enterprise's ability to generate positive future net cash flows;

(b) assess the enterprise's ability to meet its obligation, its ability to pay dividends and its needs for external financing;

(c) assess the reasons for differences between net income and associated cash receipts and cash payments; and

(d) assess the effects on an enterprise's financial position of both its cash and noncash investing and financing transactions during the period."

Maximum benefits of the cash flow information will not be realized until financial analysis procedures and norms are developed and widely accepted.

Need for Cash Flows Analytical Procedures

Accounting literature provides a large volume of material that details procedures for preparation of the statement of cash flows. However, few analytical procedures that use items from the statement of cash flows are detailed in the literature. Neither Robert Morris & Associates' (RMA) Annual Statement Studies 1991 nor Dunn & Bradstreet's Industry Norms and Key Business Ratios 1992 contain any analytical procedures based on data from the statement of cash flows.

This absence of ratios suggests that maximum use of the cash flow information is not being realized. If the cash flow information is to fulfill the purposes anticipated by the Financial Accounting Standards Board, analytical tools must be developed.

Procedures of This Study

Several analytical procedures based on data from the statement of cash flows are identified, discussed and illustrated in this article. Identification of the analytical procedures may encourage discussion and ultimately contribute to the development of commonly accepted procedures based on data from the statement of cash flows. The following ratios and procedures are intended to supplement other analytical procedures currently used. The analytical procedures identified in this study will be most effective when compared with other company and industry averages or when computed for several consecutive periods to determine trends and averages for the industry or an individual firm.

Illustrations are based on the computation of the ratios derived from data in the financial statements for the fiscal years that ended in 1988, 1989 and 1990 of all 43 utility companies in the Standard and Poor's 500 Index. The utility companies were selected to illustrate various analytical procedures because they are a well defined group. No implications from the results of this study can be made to other industries because there may be significant variances among industries. All ratios in this study utilize data from the statement of cash flows, but some contain information from other financial statements.

The analytical procedures are based on statements of cash flows prepared using the indirect method. Forty-two utility companies in the study use the indirect method; one uses the direct method. Less than 3% of all companies, regardless of the industry, use the direct method (AICPA 1990, p.350). If the direct method is used, all factors used in the analytical procedures are contained in supplemental schedules of the financial statements.

Common-Sized Cash Flows From Operations

A conventional analytical procedure is to prepare a statement of income and a statement of financial position stated in percentages. These are called common-sized statements. The primary sources and relative significance of key items in a firm's cash flows can be quickly assessed through a common-sized cash flows from operations. It also enables analysts to easily compare the performance of companies that significantly differ in size. Companies in the same industry will normally be expected to have a similar percentage of their cash flows generated by each source, regardless of size.

Common-sized percentages are computed by dividing each element contained in the cash flows from operations section by total cash flows from operations. For example, net income is divided by cash flows from operations. The adjustment to net income for non-cash expenses, such as depreciation, amortization and depletion, divided by cash flows from operations is another example.

The common-sized statement of cash flows from operations, computed for the 43 utility firms in this study, is presented in Table 1 quickly reveals two key factors regarding the cash flows from operations: net income and the adjustment for non-cash expenses are the significant components in cash flows from operations, and variability is TABULAR DATA OMITTED great among the three industries and among individual firms within each industry.

Net Income to Cash Flows from Operations

One purpose of the statement of cash flows for FASB is to assess a firm's ability to generate positive net cash flows. The percentage of cash flows from operations provided by net income will facilitate this assessment.

The quality of the cash flows can be derived from the percentage of cash flows from operations provided from net income. A higher quality of cash from operations will normally be associated with firms having a net income factor that is greater than their industries' average. When the net income percentage is computed for several years, an increasing percentage of cash flows provided by net income generally indicates an increase in the quality of the cash flows. A firm whose net income generates a significant percentage of its cash flows from operations will normally be expected to have adequate funds for payment of interest and dividends and to expand capital expenditures.

This percentage for all 43 utilities is 42.75%, indicating net income provides approximately 43|cents~ of each dollar of cash flows from operation. The factor for electrical companies was 48.78%; 34.35% for gas firms; and 38% for telephone companies. Notice that there is more than a 10% difference among the utilities. Based solely on this factor, the electrical utilities' 48.78% factor indicates the highest quality of the three types of utilities.

Non-Cash Expenses to Cash Flows from Operations

On the statement of cash flows, the adjustment to net income for non-cash expenses of depreciation, depletion and amortization is the other significant factor in cash flows from operations. A higher quality of cash flows is normally indicated by a lower percentage of cash flows from operations attributable to the adjustment for non-cash expenses. Companies continually generating a significant share of their cash flows from operations from the adjustment for non-cash expenses will usually have to allocate most of their cash flows from operations to replacing capital assets. Limited cash would therefore be available for payment of dividends and expansion of operations.

The average adjustment for non-cash expenses for the utility industry is 59.43%; hence, this adjustment accounts for almost 60|cents~ of each dollar of cash flows from operations. The percentages range from 52.34% for electrical utilities to 68.33% for gas firms. Based solely on this one factor, the electrical industry enjoys a significant advantage of more than 14% over the other two industries.

The data in Table 1 reflect a relatively high percentage of cash flows generated by the adjustment for non-cash expenses. This high percentage can probably be attributed to the fact that the utility industry has very large investments in depreciable assets. Companies in other industries not as capital intensive would probably have a much smaller percentage. This percentage generally has an inverse relation to the percentage for net income.

Industry Variability

The second key observation that can be made from data in Table 1 is the large variability among the three types of utilities. Comparison of each factor among the three types of utilities indicates this wide range. In this study, the average percentage of cash flows provided by net income ranges from 34.35% for gas companies to 48.78% for electrical firms. The adjustment for non-cash expenses ranges from 52.34% for electrical companies to 68.33% for gas companies.

The wide range of variability within the industry is a warning sign to use caution when evaluating firms. Among components of the utility industry, it indicates that firms in other industries would be expected to have significantly different percentages from those identified in this study. For example, companies engaged in the service industry usually have a substantially smaller percentage of their total assets classified as depreciable; therefore, the adjustment for non-cash expenses are much less for service firms than utilities.

Other Factors in Cash Flows from Operations

The percentages for the adjustment to net income for deferred taxes range from 7.57% for electrical to -.26% for telephone companies. The average percentage for all utilities is 4.84%. Based on the averages for the 43 utilities, none of the other factors have statistically significant differences among the three groups.

Although the factors may be small, analysis of each may contribute additional insight into the firm's financial position. Significant adjustments to net income for increases of accounts payable, decreases of accounts receivable and/or decreases of inventory might indicate that the firm is experiencing a cash flow problem. To gain additional financial insight, this information could supplement statement analysis that utilized the current and/or the quick ratio.

Solvency Analysis

Another purpose of the statement of cash flows for FASB is to provide information to enable investors and creditors to assess a firm's ability to meet its legal obligations and to pay dividends. The ratio of interest paid to cash flows from operations signifies the firm's ability to meet current obligations for interest. The relationship of cash flows from operations to dividends indicates the adequacy of the cash flows to pay dividends. These two ratios, based on cash flow information, supplement the traditional "dividend-income payout ratio" and "interest expense-income payout ratio."

Interest Payout Ratio

The adequacy of cash flows to cover interest paid is a ratio that should be of particular interest to analysts. Creditors, particularly long-term creditors, are concerned about a company's continuing ability to meet its required interest payments when they mature. The normal financial ratio computed to measure this attribute is the "times interest earned ratio" which uses interest expense. A better measure of the firm's interest-paying ability is to use interest paid and cash flows from operations to compute an interest payout ratio.

To compute this ratio, interest paid and income taxes paid are added to cash flows from operations. These items are added because they are deducted in the computation of net income. The interest payout ratio, based on data from three years, for the individual utility firms is computed by dividing cash flow from operations plus interest paid and income taxes paid by interest paid.

The three-year average for individual utility firms reveals a range of 8.0563 to 1.8881. The average for all utilities is 4.0396. Telephone companies generate approximately $6.03 of cash flows from operations for each dollar paid for interest. Higher ratios indicate less risk that the firm will have insufficient cash available to fulfill its legal obligation to pay interest.

Dividend Payout Ratio

The risk that a firm may not have sufficient cash to continue payment of cash dividends is a major concern of many investors; therefore, a ratio TABULAR DATA OMITTED TABULAR DATA OMITTED that helps assess this risk will be of interest to many investors. A dividend payout ratio based on cash flows from operations will help assess that risk. This ratio could supplement financial analysis based on the traditional "dividends-income payout ratio" that is based on earnings.
Table 2
Ratio of Cash Flows from Operations to Interest Paid
 Electrical Gas Telephone All
Three-year average 3.662 3.4344 6.0322 4.0396
Maximum value 6.0989 6.5451 8.0563 8.0563
Minimum value 2.0267 1.8881 4.5240 1.8881


Cash flows from operations minus preferred dividends paid yields the cash flow available to owners of common stock. Cash flows from operations minus preferred dividends divided by common stock dividends paid indicates the number of times common stock dividends were generated by cash flows from operations. This dividend payout ratio provides evidence of the firm's ability to meet normal cash dividend requirements with cash flows from operations.

The dividend payout ratios of individual firms, summarized in Table 3, ranges from 12.6692 to 1.4218 for different utility firms. The average for all utilities is 3.4970. The 43 utilities produce approximately $3.50 of cash flows from operations for each dollar of common stock dividends paid.

Obviously, a high dividend payout ratio indicates less risk that a firm may fail to declare a dividend due to cash flow problems. A lower ratio indicates a greater risk. This ratio could be used to compare the safety of common stock dividends among different firms. It also could be used to assess the changing risk of an individual firm. A continually declining payout ratio indicates that the risk associated with the payment of common stock dividends is increasing.

Long-Term Debt Retirement Ratio

The third solvency ratio in this study is computed to indicate the time required for firms to produce enough cash flows from operations to retire all outstanding bonds. To compute this ratio, bonds payable is divided by cash flows from operations. This ratio is computed similar to the traditional "payback period" computation. The computation of this ratio provides additional information to supplement other solvency ratios, such as the debt-to-equity ratio.

The key assumption of this debt retirement ratio is that all cash flows from operations would be committed solely to the retirement of the bonds. While one year's ratio is useful, this ratio would be most useful when computed for several years to help reveal the company's trend. A decreasing ratio indicates that the firm's bondholders are improving their financial position.

The long-term debt retirement ratios, presented in Table 4, disclose that electrical and gas companies require approximately five years to retire all outstanding bonds if all cash flows from operations are used for debt retirement. However, telephone companies could retire their bonds in approximately two years. Based on this ratio, the telephone companies enjoy a very favorable position.

Cash Flow Measures

Earnings per share, price to earnings ratio and return on assets are all based on net income. Since earnings do not necessarily equate to cash flows, computations of ratios based on cash flow data provide valuable analytical tools.
Table 5
Price to Cash Flow Ratio
 Electrical Gas Telephone All
Three-year average 5.30 6.94 5.80 5.85
Maximum value 7.73 11.51 7.92 11.51
Minimum value 2.71 4.82 4.65 2.71
Table 6
Ratio of Revenues to Cash Flows from Operations
 Electrical Gas Telephone All
Three-year average 4.4298 10.8933 3.1425 5.9940
Maximum value 6.3731 21.8497 4.1476 21.8497
Minimum value 3.0204 3.3852 1.2509 1.2509
Table 7
Ratio of Total Assets to Cash Flows from Operations
 Electrical Gas Telephone All
Three-year average 13.5805 15.8914 7.7152 13.1342
Maximum value 36.8319 24.3549 8.7229 36.8319
Minimum value 6.1079 9.6139 6.7060 6.1079


Cash Flow Per Share

Computation of cash flow per share would quickly identify trends in cash flows on a per share basis. The FASB recommended that cash flow per share not be reported in annual financial statements out of concern that some investors could confuse cash flow per share with earnings per share. However, the Board's recommendation does not diminish the value that knowledgeable investors could realize from computation of cash flow per share of common stock.

The first step in the computation of cash flow per share is to subtract preferred dividends paid from cash flows from operations. This computation determines the cash flow to common stockholders after fulfilling obligations to preferred stockholders. The second step is to divide the cash flow minus preferred dividends by the average number of shares of common stock outstanding. Cash flow per share of firms in this study ranges from a high of $16.04 to a low of $1.90, the average being $6.15. Comparison of the cash flow per share for the same company over several years identifies trends. An increase of cash flow per share over several years indicates the company is gaining financial strength.

Disclosure of cash flow per share for the different groups in this study is not made because comparison among firms has limited benefits. For example, to state that a firm has cash flow per share of $4 has limited benefits until the market price per share is considered. Two firms, each having a cash flow of $4 per share, would not be equally attractive if one sells for $20 per share and the other for $100. The same limitation applies to earnings per share.

Price to Cash Flow Ratio

Some limitations of earnings per share and cash flow per share are overcome when the common stock price is included in the computation. The price-to-earnings ratio is computed by dividing the price of common stock by earnings per share. A similar computation is the price-to-cash flow ratio. The market price of common stock is divided by the cash flow per share of common stock. Each ratio complements the other when used to analyze a firm and to compare different firms.

The price-cash flow ratios of the utility firms are listed in Table 5. The ratio ranges from a high of 11.51 to a low of 2.71 (the industry average is 5.85). This average indicates that almost six years is required to generate enough cash flows from operations to equal the market price of its common stock. The ratio could supplement financial analysis using the traditional price-to-earnings ratio and/or payback period.

Revenue to Cash Flow Ratio

Another ratio to measure a firm's ability to generate cash flows from operations is computed by dividing the firm's revenues by cash flows from operations. This ratio, presented in Table 6, identifies the average amount of revenue the firm requires to produce one dollar of cash flows from operations. Lower ratios indicate the firm enjoys a favorable ability to produce cash flows from its revenue. The analyst would be able to project the cash flows from operations based on the firm's budgeted revenues.

Telephone companies produce one dollar of cash flows for every $3.14 of revenue realized, as compared to gas companies, which require $10.89. Bear in mind this also means that while the telephone companies are able to generate cash flow from operations at three times the rate of the gas companies, cash flows will decrease three times faster for telephone companies than gas companies should revenues decline.

Asset Efficiency Ratio

A ratio to measure how efficiently a company uses its assets is computed by dividing total assets by cash flows from operations. Firms that are able to produce significant cash flows per dollar invested in assets have a low ratio, indicating more dollars of cash flows from operations are produced per dollar invested in assets. This ratio supplements analysis based on the return on assets and investment turnover ratios.

The average ratio of all firms is 13.1342 (see Table 7). This ratio indicates the utilities have an average investment of $13.13 in assets for each dollar of cash flows from operations generated. Based on total assets, telephone companies produce twice the cash flows per dollar invested when compared to gas firms.

Conclusion

The financial analysis procedures identified and illustrated herein are intended to supplement the traditional procedures regularly used by investors, creditors, analysts and management. The maximum benefits of cash flow information can be achieved through the development and acceptance of procedures and norms that utilize cash flow data. Refinement of these procedures and development of additional ones will provide financial tools for evaluating the past performance of a company and for projecting a firm's future performance.

References

1 AICPA 1990. Accounting Trends and Techniques. 44th edition. New York, NY.

2 Annual Statement Studies 1991. Robert Morris Associates: Philadelphia, PA.

3 Industry Norms and Key Business Ratios 1991-1992. Dunn and Bradstreet Information Services: Murray Hill, NJ.

Robert E. Whitis, DBA, CPA, is professor of accounting at Arkansas State University.

Keith W. Smith, PhD, CPA, is assistant professor of accounting at Arkansas State University.
COPYRIGHT 1993 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Whitis, Robert E.; Smith, Keith W.
Publication:The National Public Accountant
Date:Aug 1, 1993
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