Price cash flow ratio

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). In the second category, ratios used to assess a company's strength on an ongoing basis, we like total free cash (TFC), cash flow adequacy (CFA), cash to capital expenditures and cash to total debt.

Lenders, rating agencies and analysts use all of these. Auditors should know when and how to use them, too.

HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS

Creditors and lenders began using cash flow ratios because those ratios give more information about a company's ability to meet its payment commitments than do traditional balance sheet working capital ratios such as the current ratio or the quick ratio. When a loan officer evaluates the risk she is taking by lending to a particular company, her greatest concern is whether the company can pay the loan back, with interest, on time. Traditional working capital ratios indicate how much cash the company had available on a single date in the past. Cash flow ratios, on the other hand, test how much cash was generated over a period of time and compare that to near-term obligations, giving a dynamic picture of what resources the company can muster to meet its commitments.

Operating cash flow (OCF) ratio. The numerator of the OCF ratio consists of net cash provided by operating activities. This is the net figure provided by the cash flow statement after taking into consideration adjustments for noncash items and changes in working capital. The denominator is all current liabilities, taken from the balance sheet. Operating cash flow ratios vary radically, depending on the industry. For example, the gaming industry generates substantial operating cash flows due to the nature of its operations, while more capital-intensive industries, such as communications, generate substantially less. The gaming giant, Circus Circus, exhibited an OCF of 1.737 for fiscal year 1997 while the media king, Gannett, produced an OCF of 1.148 for a similar period. In order to judge whether a company's OCF is out of line, an auditor should look at comparable ratios for the company's industry peers. (For further details, see the case study on pages 54-55.)

Operating cash flow (OCF)

Cash flow from operations / Current liabilities

Company's ability to generate resources to meet current liabilities

Funds flow coverage (FFC) ratio. The numerator of the FFC ratio consists of earnings before interest and taxes plus depreciation and amortization (EBITDA), which differs from operating cash flow. Operating cash flow includes cash paid out for interest and taxes, which EBITDA does not. The FFC ratio highlights whether the company can generate enough cash to meet these commitments (interest and taxes). Accordingly, interest and taxes are excluded from the numerator. The denominator consists of interest plus tax-adjusted debt repayment plus tax-adjusted preferred dividends. To adjust for taxes, divide by the complement of the tax rate. All of the figures in the denominator are unavoidable commitments.

An auditor can use the FFC ratio as a tool to evaluate the risk that a company will default on its most immediate financial commitments: interest payments, short-term debt and preferred dividends (if any). If the FFC ratio is at least 1.0, the company can meet its commitments--but just barely. To survive in the long run, any company must have enough cash flow to maintain plant and equipment. To be really healthy, it should be able to reinvest cash for growth. Accordingly, if a company's FFC is less than 1.0, the company must raise additional funds to meet current operating commitments. To avoid bankruptcy, it must keep raising fresh capital.

Funds flow coverage (FFC)

EBITDA / (Interest + Tax-adjusted* debt repayment + Tax-adjusted(*) preferred-dividends)

Coverage of unavoidable expenditures

(*) To adjust for taxes, divide by the complement of the tax rate.

Cash interest coverage ratio. The numerator of cash interest coverage consists of cash flow from operations, plus interest paid plus taxes paid. The denominator includes all interest paid--short term and long term. The resultant multiple indicates the company's ability to make the interest payments on its entire debt load. A highly leveraged company will have a low multiple, and a company with a strong balance sheet will have a high multiple. Any company with a cash interest multiple less than 1.0 runs an immediate risk of potential default. The company must raise cash externally to make its current interest payments.