Many financial statement users find the cash flow from operating activities section to be quite informative. Creditors, for example, recognize that loans can only be repaid with cash and that a firm’s operations are a likely source of cash for debt repayment. Because the ability to generate cash determines dividends and share price, shareholders and their advisors are interested in cash provided by operating activities. Moreover, some analysts believe that because reported net income can be manipulated by accounting ploys, cash flow from operating activities is a more reliable performance measure than net income. This post describes how cash flow from operating activities can be used in analyzing the financial performance of a business. Enjoy!
Before going further please keep in mind, however, that not all healthy firms have a large positive cash flow from operations. Firms that experience growth in sales invariably need to expand their accounts receivable and inventory.These asset acquisitions must be financed, and cash generated by operations is a frequently used source.
A Case Study
Digital Power Corp., which designs, develops, and manufactures component parts for computers and other electronic equipment, increased its sales from $13,835,008 in 2006 to $18,884,259 in 1997. Digital’s 36% increase in sales was accompanied by a $1,673,340 increase in accounts receivable and inventory. So even though net income increased 21% to $1,400,790, the increased investment in receivables and inventory resulted in a net cash outflow from operating activities of $80,252 in 1997. In Digital’s case, the cash outflow does not indicate poor operating performance. Instead, it reflects growth. In general, however, a negative cash flow from operating activities should prompt further investigation.
To illustrate the insights that can be drawn from cash flow numbers, consider below exhibit,which contains Lie Dharma Incorporated’s statement of cash flows.
Additional information that will be helpful in interpreting the cash flow statement is in the second exhibit below:
First, note that Lie Dharma chose the indirect format for the operating section of the cash flow statement. Because of this, the specific sources and uses of cash are not detailed. We will soon show how to estimate some of these numbers. The bottom of the operating section shows that a positive cash flow of $14,428,000 was generated by operating activities. Keep in mind, however, that this figure does not reflect the cash spent to replace worn-out equipment.
Ratios Can Be Computed from The Statement Of Cash Flow
This section describes several ratios that can be computed from the statement of cash flows. Because the statement of cash flows is a relatively recent addition to IFRS, the development of cash flow ratios is at an early stage, and there is no general consensus about which ratios are the most informative. Also note that some of these ratios require information disclosed only by the direct approach for preparing the operating activities section. We will illustrate ways to estimate this information from statements of cash flows using the indirect approach.
Cash Return on Assets
The cash return on assets ratio is calculated by adding interest payments to cash flow from operating activities and then dividing by average total assets:
Cash return on assets
= [Cash Flow From Operating Activities – Interest paid] / Average total assets
Cash return on assets measures management’s success, given the assets entrusted to it, in generating cash from operating activities. Because cash flow from operating activities is available to pay dividends and to finance investments, a high ratio is desirable.
Interest payments are added to cash flow from operating activities in the numerator for the same reason that interest expense was added to net income in the return on assets calculation. That is, cash return on assets is designed to measure management’s success in making operating decisions. Because interest payments are determined by financing decisions, and because they have already been subtracted in calculating cash flow from operating activities, they are added back.
Lie Dharma’s 2008 cash return on assets is:
Cash return on assets
= [Cash Flow From Operating Activities – Interest paid] / Average total assets
= [$14,428 – $533] / [($155,603 – $134,561) / 2]
Lie Dharma’s cash return on assets appears reasonable,but it does not compare very favorably to the prior year when operating activities generated $22,686,000 and the cash return on assets was 18.7%. What caused the decline in cash flow? Statements of cash flows prepared under the indirect approach show the adjustments needed to convert net income to cash generated by operations. Lie Dharma’s largest adjustment is $10,072,000 for inventory. That is, inventory increased by approximately $10 million and that inventory expansion was essentially funded from operations. The advisability of increasing inventory holdings is usually assessed by comparing the percentage increase in sales to the percentage increase in inventory. Sales increased only 4.3% [($172,428/$165,248) – 1],while inventory increased 54.3% ($28,626/$18,554 – 1). Thus, the decline in Lie Dharma’s cash return on assets raises concerns about its inventory management or the salability of its inventory.
Some analysts question the use of cash flow from operating activities in cash return on assets and other ratios. Their reservation is that cash flow from operating activities makes no provision for replacing worn-out equipment. These expenditures are necessary to maintain productive capacity and current operating levels. Because cash flow from operating activities is not reduced for these expenditures, it overstates the amount of discretionary cash flow generated from operations.
Instead of using cash flow from operating activities in ratio calculations, some analysts use “free cash flow“. One way to calculate free cash flow is to subtract from cash flow from operating activities the cash payment necessary to replace worn-out equipment. Unfortunately, firms rarely disclose this figure. Although the investing activities section of the statement of cash flows shows total payments for the acquisition of productive assets, the amounts spent to (1) replace assets and (2) expand productive capacity are not detailed. Because of this, depreciation expense is sometimes used as an imperfect estimate of the cash expenditure needed to maintain productive capacity. Because depreciation expense is based on historical cost, it probably understates the cash necessary to replace productive assets.
Quality of Sales
The quality of sales ratio is computed by dividing cash received from customers by sales (revenue): All other things being equal, a firm is in a more advantageous position if a large portion of its sales is collected in cash. Not only is final realization of the transaction assured, but the investment in accounts receivable is minimized.
This ratio is particularly useful for analyzing firms that use liberal revenue recognition policies or firms that, of necessity, employ revenue recognition policies that require the use of judgment. In both of these situations, a deterioration of this ratio over time might indicate that a firm is inflating earnings by the use of questionable accounting judgments. For example, some of Lie Dharma’s sales arise from firm contracts with other businesses for the design and manufacture of custom-made products. Although Lie Dharma records revenue at the time goods are shipped, it could argue for using the more liberal percentage-of-completion method. Utilizing this procedure too aggressively would likely result in recognizing significant amounts of revenue before cash is collected and would be reflected in a low quality of sales ratio.
The quality of sales ratio can also reflect a firm’s performance in making collections from customers. Suppose that a firm increases sales by the questionable strategy of reducing the credit standards that customers must meet. These customers are likely to be relatively tardy in making payments. This situation will be revealed to financial statement readers by a declining quality of sales ratio.
Lie Dharma’s quality of sales ratio cannot be computed from the information shown in the very first exhibit above. Why not? The numerator, cash received from customers, is available only from the cash flow statement under the direct approach. However, this figure can be approximated by the following relationship:
To understand this relationship, recognize that both the beginning balance in accounts receivable and sales for the year might potentially be collected in cash during the current year. In fact, the sum of these two amounts is collected in cash, except for the balance that remains in accounts receivable at the end of the year.
Lie Dharma’s estimated cash collections from customers is $171,487 (in thousands).
Lie Dharma’s quality of sales ratio for 2008 is 99.5%.
Quality of sales
= Cash received from customers / Sales
= $171,487 / $172,428
This is a very high quality of sales ratio and reflects good accounts receivable management and conservative revenue recognition policies.
The next case study describes how the quality of sales ratio provides useful insights into the software industry.
Several firms in the software industry have been criticized for their revenue recognition policies. The allegations suggest that these firms have recognized revenue prematurely. Such a practice would not only overstate sales, but net income as well. Revenue overstatements can be achieved in various ways. Some companies were said to double-bill customers. Other companies booked revenue when they shipped goods to their own warehouses in foreign countries.
Ultimately, such practices catch up with companies. For example, Oracle Corporation paid $24,000,000 to settle shareholder lawsuits, and Cambridge Biotech Corporation was forced to file for bankruptcy.
The quality of sales ratio can help investors detect and avoid such situations. Consider the following information for two software companies.
a. Estimate the cash collected from customers for each firm.
b. Compute the quality of sales ratio for each firm.
c. What do you conclude from these ratios?
a. Cash Collected from customers for each firm:
b. Quality of Sales:
c. These ratios are considerably below 100%. This should certainly prompt financial statement readers to undertake further investigation.
Quality of Income
The quality of income ratio is computed by dividing cash flow from operating activities by net income:
Quality of income = Cash Flow From Operating Activities / Net income
This ratio indicates the proportion of income that has been realized in cash. As with quality of sales, high levels for this ratio are desirable. The quality of income ratio has a tendency to exceed 100% because (1) depreciation expense has reduced the denominator and (2) cash spent to replace productive assets has not been subtracted in calculating the numerator. Lie Dharma’s 2008 quality of income ratio is 98.4%.
Quality of income = $14,428 / $14,667 = 98.4%
Lie Dharma’s 2008 ratio is less than 100% and does not compare favorably to its 2007 ratio of 128%.The decline in this ratio is largely due to the growth in inventories that was mentioned previously.
In the discussion of quality of sales, we indicated that revenue recognition may be judgmental. The same is true with expense recognition. A variety of alternatives for expense allocations are available to firms, and firms have considerable discretion in the selection of these alternatives. The quality of income ratio can provide an overall indication of how liberal a firm’s accounting judgments have been.
Cash flows can be manipulated by management. For example, customers can be induced to remit payments early if they are provided with a sufficiently large cash discount. Although the short-term consequences of this action may be to increase net cash flow, large discounts might not be in the shareholder’s best long-term interest.
Cash Interest Coverage
The cash interest coverage ratio is used by creditors to assess a firm’s ability to pay interest. It is calculated by summing cash flow from operating activities, interest payments, and tax payments and then dividing by interest payments. Interest and tax payments are added to cash flow from operating activities because they have been subtracted in the calculation of cash flow from operating activities and because those payments are available to cover interest. In particular, tax payments are added because in the unfortunate case of zero profitability, those paymentswould not be made and would provide another measure of relief for the creditors. Interest and taxes paid are usually summarized at the bottom of the statement of cash flows.
Cash interest coverage
= [Cash Flow From Operating Activities + Interest paid + Taxes paid] / Interest paid
The cash interest coverage ratio reflects how many times greater cash provided by operations is than the interest payment itself. Creditors prefer high levels of this ratio. Lie Dharma’s 2008 cash interest coverage ratio is 4,168% or 41.68:
Cash interest coverage = [$14,428 + $533 + $7,256] / $533 = 4,168%
This ratio is quite high and should provide creditors with considerable assurance that Lie Dharma is currently generating more than enough cash to meet its interest payments.
Accounting10 years ago
Check Payment Issues Letter [Email] Templates
Accounting11 years ago
What is Journal Entry For Foreign Currency Transactions
Accounting7 years ago
Accounting for Business Acquisition Using Purchase Method
Accounting11 years ago
Journal Entry for Correction Of Errors and Counterbalancing