Academic journal article Journal of Accountancy

Developing Ratios for Effective Cash Flow Statement Analysis

Academic journal article Journal of Accountancy

Developing Ratios for Effective Cash Flow Statement Analysis

Article excerpt

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.

PURPOSE OF THE STATEMENT

OF CASH FLOWS

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.

CONTENTS OF CASH FLOWS

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.

ASSESSING SOLVENCY

AND LIQUIDITY

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. …

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