It’s easy to see that financial statements contain a lot of data. Making sense of that data is not so easy. But teasing out connections between the numbers can unlock their meaning.
Calculate the Cash Flow Ratio
Cash flow is crucial for a company’s long-term viability. The cash flow ratio, or CFR, helps assess how a company’s cash flow compares to its obligations, which is a sign of its solvency. Computing CFR involves two numbers. First is cash provided by operating activities, or operating cash flow, which is found on the statement of cash flows. Next is current liabilities, which is found on the balance sheet. To compute CFR, divide operating cash flows by current liabilities.
Assume for its most recent fiscal year, a company called GrowCo had $30,000 of operating cash flow and $90,000 of current liabilities as of the end of the year. Its CFR would be 0.33.
Several factors affect the CFR:
- Raising profit yields a higher operating cash flow, lifting the CFR. This holds as long as the higher profit isn’t due to lower depreciation expense. Depreciation is a noncash cost and has no effect on operating cash flow or the CFR.
- Reducing accounts receivable and inventory balances through better working capital management increases operating cash flow, which raises the CFR.
- Increasing liabilities such as accounts payable by negotiating longer payment terms with suppliers increases operating cash flow, which raises the CFR.
- Decreasing liabilities by repaying a short-term bank loan has no effect on operating cash flow but decreases current liabilities and increases the CFR.
Evaluate Cash Flow Ratio Results
In most cases, a single amount or ratio offers little information to a user. To make more sense of the numbers, you can do three types of comparisons: period-to-period contrasts, peer-to-peer contrasts, and comparisons to other ratios.
As a further illustration, assume two other companies, SlowCo and ChaosCo, had the same operating cash flow and current liabilities as GrowCo in the example above. For year one, all three companies had a 0.33 CFR. Assume at the end of the following year, GrowCo’s CFR was 0.55, SlowCo’s was 1.13, and ChaosCo’s was negative 0.27.
With period-to-period trends, you compare one measure within the same company over multiple periods. GrowCo’s CFR improved, from 0.33 to 0.55, which, absent other information, would not raise any flags. SlowCo’s CFR improved by a large amount, while ChaosCo’s situation appears to have declined at an alarming rate. You’d want to dig further into what caused these significant changes from one year to the next.
With peer-to-peer comparisons, you contrast ratios among similar companies to identify outliers. In the example above, you’d likely want to understand what makes SlowCo’s performance so different from ChaosCo’s.
A third layer involves trends across multiple ratios. To complement the CFR, you could look into performance or working capital ratios. For example, with SlowCo, you might see that sales decreased from one year to the next, or the company improved how it managed accounts receivable and inventory. These changes would raise CFR. With ChaosCo, you might see a significant increase in sales, coupled with much higher accounts receivable and inventory balances. If you were a creditor to this company because you loaned money to it or are a supplier, you’d want to monitor how well it was managing its growth.
The CFR is a useful solvency indicator. Keeping an eye on this ratio and other metrics can provide you with important insight into a company’s ability to pay its bills. This is true whether the company is your own, or one with whom you do business.