Academic journal article Journal of Accountancy

The Power of Cash Flow Ratios

Academic journal article Journal of Accountancy

The Power of Cash Flow Ratios

Article excerpt

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 artifice, 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 investors--and leveraged buyout 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 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 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 less inventory/current liabilities). According to 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 (OCF), funds flow coverage (FFC), cash interest coverage (CIC) and cash debt coverage (CDC). …

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