Cash Flows: Another Approach to Ratio Analysis

Cash-flow-based ratios are useful in evaluating a company's financial strength and profitability. One product of accounting evolution in the United States is the use of ratios for analyzing financial statements. Originally developed as short-term credit analysis devices, ratios can be traced as far back as the late 19th century. Since then, analysts have developed many financial ratios that are widely used by practitioners and academicians. A relatively recent development has been the Financial Accounting Standards Board requirement to prepare a statement of cash flows. To date, little has been done to suggest a comprehensive set of cash flow ratios with the potential to evaluate financial performance. Scattered empirical evidence in published studies does not identify a complete set of useful ratios. Relative performance evaluation is one important use of cash flow ratios, which can be viewed in terms of sufficiency and efficiency. Sufficiency describes the adequacy of cash flows for meeting a company's needs; efficiency describes how well a company generates cash flows relative both to other years and to other companies. This article proposes some cash-flow-based ratios that can be used for relative performance evaluation. We conducted an empirical study of cash flow statements to provide some industry averages and to determine if the potential exists to develop benchmarks for the ratios by industry. These benchmarks can play an important part in evaluating the relative sufficiency and efficiency of a company's cash flows. USE OF RATIOS Analysts use ratios to predict financial variables and to evaluate relative performance. They group ratios into liquidity and profitability categories to predict bankruptcy, the probability of loan defaults and stock prices. Relative performance evaluation assumes comparing a company's performance to that of a chosen industry or benchmark ratio filters out the performance effects of common uncertainties, leaving only company-specific performance. In such evaluations, other companies' performance provides information about a specific company's performance. Although recent studies yielded apparently contradictory results, most cash flow studies show the value of cash flow data. This is especially true in predicting bankruptcy and financial distress. Little has been done with respect to using cash flow ratios for relative performance evaluation. CASH FLOW RATIOS Our study provides a starting point for developing some benchmarks (norms or standards) for cash flow ratios. The cash flows from the operating activities classification on the statement of cash flows generally summarize the cash effects of transactions and other events involved in determining net income. Operating activities involve an enterprise's primary activities - the production and delivery of goods and services. They are the enterprise's primary focus and the primary variable of interest in this study. Cash from operations is a component of each of the ratios shown in exhibit 1, page 57, which have been classified as sufficiency or efficiency to describe their potential use in relative performance evaluation. Sufficiency ratios. The cash flow adequacy ratio directly measures a company's ability to generate cash sufficient to pay its debts, reinvest in its operations and make distributions (dividends) to owners. A value of 1 over a period of several years shows satisfactory ability to cover these primary cash requirements. The long-term debt payment, dividend payout and reinvestment ratios provide further insight for investors and creditors into the individual importance of these three components. When expressed as percentages and added together, these three ratios show the percentage of cash from operations available for discretionary uses. Although a company could use cash generated from financing and investing activities to retire debt, cash from operations represents the main source of long-term funds. …