CHAPTER FOUR
Cash Flow Measurements
THOUGH MANY OF THE other ratios in this book are useful for determining a company's performance level in a variety of areas, the core issue is whether there is enough cash flowing from ongoing operations to sustain the company. This chapter deals with a variety of measurements that involve a company's cash flow. If a performance measure in this chapter yields a poor result, then action must be taken at once to ensure that corporate survival is maintained. The measures here can also be combined with the liquidity measures noted in Chapter 5. The cash flow measures in this chapter are:
| Cash Flow from Operations
Free Cash Flow Cash Flow Return on Sales Fixed Charge Coverage Expense Coverage Days Cash Flow Coverage Ratio Cash Receipts to Billed Sales and Progress Payments Cash to Current Assets Ratio |
Cash Flow to Fixed Asset Requirements
Cash Flow Return on Assets Cash to Working Capital Ratio Cash Reinvestment Ratio Cash to Current Liabilities Ratio Cash Flow to Debt Ratio Reinvestment Rate Stock Price to Cash Flow Ratio Dividend Payout Ratio |
CASH FLOW FROM OPERATIONS
Description: Under generally accepted accounting principles, a company can easily report a large income figure, even while its cash reserves are draining away. The cash flow from operations ratio can be used to determine the extent to which cash flow differs from the reported level of either operating income or net income. Any difference in the ratio that varies significantly from one is indicative of substantial noncash expenses or sales in the reported income figures. Cash flow problems are likely if the ratio is substantially less than one.
Formula: The formula can be generated in two formats. One is to divide operational cash flow by income from operations, while the second format is to divide cash flow from all transactions (including extraordinary items) by net income. The first format yields a more accurate view of the proportion of cash being spun off from ongoing operations, whereas the second version shows the impact of any transactions that are unrelated to operations. The formulas are:
Example: The Bargain Basement Insurance Company (BBIC) is opening new stores at a rapid clip, trying to gain premium locations before its key competitor, Super Low Premiums, Inc., grabs the same spots. The company is reporting net income of 20% from its operations, which is considered reasonable in the insurance business. However, it cannot understand why its bank continues to refuse additional loans to fund ongoing operational needs. The bank is concerned about BBIC's cash flow from operations ratio. The company's relevant projections are shown in Table 4.1.
The table reveals the key problem for BBIC, which is that the company is recognizing insurance as revenue before the receipt of cash from policy holders in some cases. Consequently, its rapid growth is resulting in only modest positive cash flow, which translates into a poor cash flow from operations ratio of 20%. The bank correctly finds this ratio to be indicative of BBIC's future inability to pay back a loan and so refuses to extend one.
Cautions: This ratio does not reveal the reason for variations between reported income and cash flow. The variance can be caused by significant and prolonged cash flow problems, or perhaps only a short-term issue that will not reappear, and there is no way to know unless one peruses the statement of cash flows for more detail. In short, extra information is needed to interpret this ratio properly.
FREE CASH FLOW
Description: One of the most useful measures of cash flow is free cash flow, because it includes all factors that contribute to changes in cash flow. Thus, it is a prime indicator of the financial health of a company. Also, investors use it to calculate the amount of cash flow that may be available for distribution to them as dividends.
Formula: The general concept of free cash flow is to compile the net change in cash generated by company operations, less any cash paid for working capital requirements, fixed asset purchases, and dividends. The formula is:
Example: Moxie Fitness is a chain of executive-level health clubs that charges a premium price to its clients for the use of its personal trainers and the most expensive exercise equipment. This equipment has required a substantial investment in fixed assets. In addition, the company opened five new locations in the past year. The result was the following financial information, as extracted from its year-end financial statements:
| Free Cash Flow Items | Amounts |
| Net income | $500,000 |
| + Depreciation | + 200,000 |
| – Net accounts receivable change | – 150,000 |
| + Net accounts payable change | + 75,000 |
| – Capital expenditures | – 800,000 |
| – Dividends | – 50,000 |
| = Free cash flow | – $225,000 |
The free cash flow analysis shows Moxie has a comfortable amount of cash flow from its operations, but its rate of growth is using all available cash to buy more exercise equipment.
Cautions: There are a number of situations in which a company may have positive free cash flow, though it is not really a healthy organization on a long-term basis. All of the following situations generate free cash flow, but they are not indicators of a healthy company:
- Delaying the payment of accounts payable
- Selling fixed assets or delaying fixed asset purchases
- Reducing maintenance expenditures
- Reducing marketing expenditures
In these cases, management has certainly made more cash available, but doing so may have adversely affected the long-term viability of the business.
Another issue is that free cash flow can be altered by the rate of growth of a business. If its sales are declining, it will probably be able to convert some accounts receivable back into cash, which raises its free cash flow (despite a declining business). Conversely, increasing sales requires additional working capital, which reduces free cash flow.
Consequently, you need to be aware of the general trend of a company's operations and the decisions made by management in order to evaluate whether a certain amount of free cash flow is good or bad.
CASH FLOW RETURN ON SALES
Description: This is a general measure for determining a company's ability to generate cash flow at various levels of sales volume. It is also known as cash conversion efficiency. It will tend to fluctuate in accordance with a company's step costs. For example, if a company is operating at maximum production capacity, it has reached a point at which its cash flow is likely to be maximized. If it were to increase its costs in order to add capacity, the resulting cash flow could very well drop until sales increase to the point at which incremental cash inflows exceed the incremental cash outflows associated with added production capacity.
Formula: Divide total sales into cash flow. This ratio is more useful when it is subdivided into individual product lines so managers can see which products are generating the most cash flow relative to sales volume. The formula is:
Example: The Better Back Chair Company is experiencing a dismal cash flow from its sales. The CFO decides to split the company into its various product lines to determine where the cash flow problems are the worst and organizes the information for Table 4.2.
The table reveals that only the Norwegian product line is generating a positive cash flow return on sales. Furthermore, the table reveals considerable quantities of noncash sales on two of the three product lines; extra investigation reveals that the controller has been booking sales before shipment so that sales have been artificially inflated. The CFO fires the controller and sets up better controls over the recording of sales.
Cautions: This ratio will vary considerably by industry, as well as a company's break-even level, which in turn is based on its relative level of fixed costs. Also, it may not make sense to pour more resources into a product line that generates a high ratio of cash flow return on sales if that product line has already achieved its maximum market share potential. In addition, it may be unwise to allocate more resources to a product line with a high ratio result if there are other underperforming product lines that could achieve greater cash flow returns if the proper investment were made in them now.
FIXED CHARGE COVERAGE
Description: A company may have such a high level of fixed costs that it cannot survive a sudden downturn in sales. The fixed charge coverage ratio can be used to see if this is the case. It summarizes a company's fixed commitments, such as principal payments, long-term rent payments, and lease payments, and divides them by the total cash flow from operations. A ratio close to one reveals that a company must use nearly all of its cash flows to cover fixed costs and is a strong indicator of future problems if sales drop to any extent. A company in this position can also be expected to drop prices in order to retain business, because it cannot afford to lose any sales.
Formula: Summarize all fixed expenses, leases, and principal payments for the year, and divide them by the cash flow from operations. It is generally not necessary to include dividend payments in this calculation, since this should not be considered fixed over the long term. The types of expenses and other payments that are fixed can be subject to some interpretation; for example, if a lease is close to expiring, there is no need to include it in the formula since it is a forward-looking measure, and there will be no lease payments in the future. Also, if a company is expecting to reduce its principal payments by extending a loan over a longer time period, this may also be grounds for reducing the amount of fixed payment listed in the ratio. The formula is:
Example: The owner of Dinky Dinosaur Toys is anticipating a slowdown in the sales of his high-end wooden toys in the upcoming year and wants to know what his company's exposure will be. The company's annual fixed expenses and cash flow from operations are:
| Cash flow from operations | $850,000 |
| Interest on line of credit | 80,000 |
| Interest on long-term debt | 150,000 |
| Office equipment leases | 45,000 |
| Leases expiring within current year | 10,000 |
| Expected lease on company car | 20,000 |
| Principal payments on long-term debt | 200,000 |
| Balloon payment on long-term debt | 150,000 |
If all of the fixed expenses and payments in this list were to be added together, they would total $655,000, which would represent a potentially dangerous fixed charge coverage ratio of $655,000 to $850,000, or 77%. However, there are some line items on the list that are open to interpretation. First, the upcoming balloon payment is a one-time payment; it is up to the owner's judgment if this is to be included in the ratio, since it is meant to be a long-term ratio composed of ongoing fixed expenses and payments. Second, the expected lease on the company car is not really a fixed cost since it has not yet been incurred and can be stopped at the owner's option. Also, the leases expiring within the current year can be ignored unless new leases on replacement equipment must be obtained. Another issue is the interest on the line of credit: Most lines of credit require a complete payoff at least once a year, which means that this line can theoretically be zero. For the purposes of this calculation, the owner should estimate the average interest and principal payment on the line of credit and include it in the ratio. Consequently, there is considerable room for judgment regarding the inclusion or exclusion of items that very much depend upon the purposes of this ratio and deciding what constitutes a fixed charge.
Cautions: As just noted, the simple compilation of fixed charges is not sufficient when calculating the fixed charge coverage ratio; some charges may be included or excluded, depending on how the ratio will be used. Also, an increasing number of costs may be considered fixed in the short term, whereas nearly all costs can be considered variable if a sufficiently long time frame is used. For example, if fixed costs are considered to be any costs that cannot be eliminated by management within the next month, then they must also include any purchase orders that will not be completed during that period as well as any contract that will not expire during that period. If the period is extended to more than a year, however, it is possible that even some loan payments can be successfully accelerated and completed during the intervening period, thereby eliminating them from the fixed charge list. Consequently, the time during which costs are to be considered fixed charges has a large bearing on the outcome of the ratio.
EXPENSE COVERAGE DAYS
Description: This calculation yields the number of days that a company can cover its ongoing expenditures with existing liquid assets. This is a most useful calculation in situations in which the further inflow of liquid assets may be cut off, so the management team needs to know how long the company can last without an extra cash infusion. The calculation is also useful for seeing if there is an excessive amount of liquid assets on hand, which could lead to a decision to pay down debt or buy back stock, rather than keep the assets on hand.
Formula: Summarize all annual cash expenditures, and divide by 360. Then divide the result into the summary of all assets that can be easily converted into cash. The largest problem with the formulation of this ratio is the amount of the annual cash expenditures, for there are always unusual expenses, such as fees associated with lawsuits, warranty claims, and severance payments, that may not be likely to occur again. However, if all of these additional expenses were to be stripped out of the calculation, the ratio would always be incorrect, for there will inevitably be some unusual expenditures. To correct for this problem, a company with steady long-term expenditure levels could average its expenditures over several years. Companies experiencing rapid changes in expenditure levels will not have this option, and so will have to make judgment calls regarding the most appropriate expenditures to include in the calculation. The formula is:
Example: The Chemical Detection Consortium (CDC) obtains 100% of its business from the federal government, which pays it to conduct random chemical warfare tests of airports. The CDC president is concerned that the government has not yet approved the budget for the upcoming year and cannot release funds to CDC until the date of approval. The president consequently asks the controller to calculate expense coverage days to determine how long the company can last without the receipt of any more federal funds. The controller finds that total expenditures in the preceding 12-month period were $7,450,000. The funds currently on hand are shown in Table 4.3. The calculation of expense coverage days is:
| Fund Type | Amount | |
| Cash | $48,500 | |
| Short-term marketable securities | $425,000 | |
| Accounts receivable | $620,000 | |
| Total | $1,093,500 |
Cautions: This calculation reveals only the number of days over which expenses can be paid if no other operational decisions are made. For example, if accounts payable are paid later than the normal due dates, the extension will effectively lengthen the ratio. However, if accounts payable terms have already been lengthened prior to the calculation of the ratio, then suppliers may force the company to use up cash faster than is indicated by the ratio so it can clear out its obligations. The ratio can also be misleading if the annual expenditure level used to determine the denominator does not reflect the expense level being incurred during the period covered by the ratio (typically the next few months). This is a particular problem for seasonal businesses, whose expense levels can fluctuate dramatically, depending on the time of year. The results of this calculation must consequently be viewed in the context of the current state of accounts payable and short-term expenditure levels.
CASH FLOW COVERAGE RATIO
Description: This measure is similar to the fixed charge coverage measure, which shows a company's ability to meet all of its fixed expense and payment obligations. This variation focuses attention on the ability of a company's cash flow to cover all nonexpense items, which include payments for the principal on debt, dividends, and capital expenditures. This is of particular importance to companies with heavy debt repayment burdens or companies that are rapidly expanding their fixed asset bases.
Formula: Summarize for the reporting period all principal payments (including the principal portion of capital lease payments) as well as dividend payments and capital expenditures. Then divide this by cash flow for the period. The formula is:
Example: The CFO of the rapidly expanding Perpetual Motor Company wants to make sure that there is enough cash flow to cover the company's debt and capital expenditure payments for the upcoming year. The company's budget model estimates cash flow of $10,500,000, total principal payments of $4,025,000, and capital expenditures of $6,050,000. There are no planned dividend payments. The CFO calculates the ratio as:
The CFO concludes that the budget model will generate enough cash to cover nonexpense payments; but because there is little slack in the model, the CFO decides to secure a backup line of credit to make payments on these items in case actual cash flows for the period are less than the budget predicts.
Cautions: The measure may be misleading in cases where a company has an upcoming balloon payment on its debt because the measure is historical in nature and will not show the upcoming principal payback requirement. This issue can be avoided by calculating the measurement on a forward-looking basis. The same problem arises in the case of capital expenditures because the historical pattern of expenditures may not resemble upcoming capital expenditure requirements. Once again, the problem can be resolved by including expected capital expenditures in the denominator.
CASH RECEIPTS TO BILLED SALES AND PROGRESS PAYMENTS
Description: This measure is useful for determining the amount of cash that is actually received from accounts receivable, with a 100% measure being the best possible case. It is most useful when compared to the number of days of accounts receivable outstanding because this measure may reveal that not all cash is being collected at the same time that the days of receivables calculation may be low, which indicates that the collections staff is writing off a considerable proportion of receivables rather than going to the effort of collecting them.
Formula: Divide cash receipts by the combination of billed sales and billed progress payments. Credit card sales should be included on both sides of the formula because there is no question that cash will be collected on them. The formula is:
Example: The CFO of Magma Consulting Partners is not sure if the statements of the new collections manager are accurate because the collections manager claims to have improved the average days of accounts receivable outstanding from 49 to 36 within three months. To test the validity of this claim, the CFO asks the programming staff to create a program that matches cash receipts to all billed items. This comparison of cash receipts to billed sales yields a significantly worse result than claimed by the collections manager. Further investigation reveals that the collections manager had written off all billed sales as soon as they were 40 days old, which makes his days of receivables measure look good but reduces the amount of cash collected. The CFO fires the collections manager and decides to measure the performance of the next collections manager with the cash receipts to billed sales ratio.
Cautions: It can be difficult to collect information for this measurement. The information in the denominator is simple enough to obtain, but the cash receipts figure must be derived from a precise review of actual receipts from each billing, which can be a labor-intensive process. It is not acceptable to use the grand total amount of cash receipts for a specific time because this will include cash receipts related to billings from an earlier time.
CASH TO CURRENT ASSETS RATIO
Description: The cash to current assets ratio is useful for determining the proportion of cash within the current assets category. This is the most conservative way to measure a company's liquidity because it ignores the liquidation value of accounts receivable and inventory. It is most useful for determining the ability of a company to pay off liabilities in the extremely short term.
Formula: Add together cash and short-term marketable securities, and divide by current assets. Current assets include cash, short-term marketable securities, accounts receivable, and inventory. The formula is:
Example: The Blastomatic Bobsled Company has not exhibited good control over its inventories or customer credit, resulting in a large proportion of its current assets being composed of old accounts receivable and even older inventory. A potential investor is concerned that many of the assets of these two categories will never be converted into cash. To gain a better understanding of the company's existing cash situation, the investor decides to calculate the cash to current assets ratio, using the following information from the company's balance sheet:
| Cash | $148,000 |
| Short-term marketable securities | $81,000 |
| Accounts receivable | $703,000 |
| Inventory | $2,067,000 |
This information can then be used to calculate the following cash to current assets ratio:
The ratio reveals that the company is having a very difficult time converting its inventory and accounts receivable into cash. The investor concludes that this could be a major opportunity to turn around the company with some improved management and makes a bargain-basement offer to buy the company.
Cautions: The amount of cash and short-term marketable securities on hand can vary significantly by day, given the need for payments to cover check runs and payrolls. The best way to calculate this ratio is to use an average over several time periods. If the ratio is being measured on a trend line, then an alternative is to calculate it for the same date within each month (presumably the last day), when the short-term impact of check runs and payrolls will be similar from month to month.
CASH FLOW TO FIXED ASSET REQUIREMENTS
Description: This is a useful measure for determining whether a company can fund expected fixed asset purchases with internally generated funds. If the ratio indicates a cash shortfall, then a company must either curtail its asset-purchasing expectations or go to an outside source for additional funding.
Formula: Divide the total dollar amount of budgeted fixed asset purchases into annual cash flow. The basic formula is:
The formula can be expanded to include other nonexpense payments, such as dividends and principal payments on loans, to gain a more accurate picture of a company's ability to purchase fixed assets. This expanded version of the formula is:
Example: Monty's Fun Park needs to acquire a new roller coaster for the upcoming summer season. The owner has no need to distribute dividends, but must make principal payments on amusement equipment purchased in previous years. The relevant information is shown in Table 4.4.
| Fund Type | Amount |
| Net income | $725,000 |
| Depreciation | $125,000 |
| Principal payments | $350,000 |
| Budgeted fixed asset purchases | $800,000 |
Based on this information, the ratio calculation is:
Since the ratio results in a value of less than one, the owner will have to obtain a loan to help him purchase the roller coaster.
Cautions: Cash flows can be altered by the presence of one-time expenses, some of which will appear in a company's financial statements from time to time. Accordingly, one should provide for these extra expenses in the ratio to ensure that the company has sufficient funds on hand to weather any unusual cash requirement situations. Also, if the ratio results in a figure close to 100%, management may want to arrange for a line of credit even if the amount of cash flow is sufficient, to leave itself with a reserve source of cash to cover contingencies.
CASH FLOW RETURN ON ASSETS
Description: This calculation is used to determine the amount of cash that a company is generating in proportion to its asset level. It can be used as a substitute for the popular return on assets measure, since the net income figure used in the return on assets calculation is subject to greater manipulation through the use of noncash accounting entries.
Formula: Add together net income and any noncash expenses such as depreciation and amortization. Then subtract from this amount any noncash sales, such as revenue that has been recognized but not yet billed. Then divide the result by the net value of all assets. This should include accounts receivable net of a bad debt reserve, inventory net of an obsolescence reserve, and fixed assets net of depreciation. The formula is:
Example: The president of the Glowering Tail Light Company, resellers of 1950s-era taillights, has been told by the controller for several years that the company has a sterling return on assets. The president would like to verify this by comparing the measure to the cash flow return on assets and, therefore, collects the information shown in Table 4.5.
| Return on Assets | Cash Flow Return on Assets | |
| Net income | $1,000,000 | $1,000,000 |
| Depreciation | +$105,000 | |
| Pension fund gains | –$45,000 | |
| Bill and hold revenue | –$132,000 | |
| Percentage of completion revenue | –$154,000 | |
| Total assets | $3,250,000 | $3,250,000 |
| Measurement | 30.8% | 23.8% |
The return on assets figure listed at the bottom of the table is derived by dividing net income of $1,000,000 by total assets of $3,250,000. To arrive at the cash flow return on assets, the president must add back the noncash depreciation expense and then subtract a series of noncash accounting entries that have artificially increased the revenue level. The result is:
Though the cash flow return on assets percentage is acceptable, it is also considerably less than the reported return on assets.
Cautions: A company's managers can enhance their performance under this measurement by severely restricting the amount of fixed assets in which they are willing to invest cash. Though the intent of the measure is precisely this kind of behavior, it can also result in old assets not being replaced in a timely manner, which may cause capacity shortfalls when equipment fails. Managers may also interpret this measure in a conservative way when dealing with new products, since they may not want to invest in untried equipment or new products that will require large investments with an uncertain payoff.
CASH TO WORKING CAPITAL RATIO
Description: This ratio is useful for determining the proportion of working capital that is made up of cash or investments that can be readily converted into cash. If the ratio is low, it may be an indication that a company will have trouble meeting its short-term commitments because of a lack of cash. If this were the case, the next formula to calculate would be the number of expense coverage days (described earlier in this chapter) to determine exactly how many days of operations can be covered by existing cash levels.
Formula: Add together the current cash balance as well as any marketable securities that can be liquidated in the short term, and divide the total by current assets less current liabilities. The key issue is which investments to include in the measurement: Since this is intended to be a measure of short-term cash availability, any investments that cannot be liquidated in one month or less should be excluded from the calculation. The formula is:
Example: The Arbor Valley Tree Company has a large inventory of potted plants and trees on hand, which makes up a large proportion of its inventory and is recorded as part of current assets. The inventory turns over only three times per year, however, which does not make it very liquid for the purposes of generating short-term cash. The company's financial analyst wants to know what proportion of the current ratio is really composed of cash or cash equivalents, since it appears that a large part of working capital is skewed in the direction of this slow-moving inventory. The relevant information is shown in Table 4.6.
| Fund Type | Amount | Liquidity |
| Cash | $55,000 | Immediately available |
| Money market funds | $180,000 | Available in one day |
| Officer loan | $200,000 | Due in 90 days |
| Accounts receivable | $450,000 | Due in 45 days |
| Inventory | $850,000 | Turnover every 4 months |
| Current liabilities | $450,000 | Due in 30 days |
Based on this information, the financial analyst calculates the cash to working capital ratio as:
The financial analyst did not include the note receivable from the company officer, since it would be available for 90 days. This nearly halved the amount of the ratio to 18%, which reveals that the company should be extremely careful in its use of cash until more of the accounts receivable or inventory balances can be liquidated.
Cautions: This measurement can be considerably skewed by the timing of the measurement within the reporting period. For example, if a company has one large accounts payable check run scheduled each month, then its cash reserves will look large just before the check run and much lower afterward; the same situation will apply to payroll. In these situations, the measurement will drop precipitously right after the payment event, making the company cash situation look much worse than it really is.
CASH REINVESTMENT RATIO
Description: This ratio is useful for determining the amount of cash flow that a company is routinely plowing back into the business. This can be indicative of a strong commitment by the owners to build the business. However, it can also mean that a company is being so poorly run that it requires an excessive amount of working capital and fixed assets to stay in business.
Formula: To calculate the ratio, summarize cash flow for the period, subtract any dividends paid, and then divide the result by the combined incremental increase in both fixed assets and working capital. When determining the incremental increase in fixed assets, be sure to factor out the net impact of any fixed asset sales during the period—otherwise, the incremental increase in assets due to the acquisition of assets will appear to be deflated. An alternative calculation is to eliminate changes in working capital from the numerator, which allows one to focus on the key investments being made in a company's plant and equipment. The formula is:
Example: An investor wants to determine the amount of cash flow reinvestment for a target company. It is in a growth industry, and a high rate of reinvestment is expected. The ratio is:
From the investor's perspective, the target company does not appear to be investing a sufficient quantity of its cash flow back into the business. In a high-growth situation, a company should not only be reinvesting 100% of its cash flow, but also scrambling to line up additional funding for yet more reinvestment. The investor should closely question the management team regarding the company's perceived slow rate of internal asset growth.
Cautions: As noted in the description, this ratio can be an indicator of a continuing commitment to a business or mismanagement that requires the continual addition of assets to stay in business. To see if the underlying issue is related to mismanagement, calculate the ratio of fixed assets to revenue and see how this correlates to the same ratio for other businesses in the same industry. The ratio of working capital to sales can be used in the same fashion. If these ratios indicate unusually high proportions of assets or working capital within the business, then there is either some mismanagement of assets or the company's operational structure is so different from other businesses that their results are not comparable.
CASH TO CURRENT LIABILITIES RATIO
Description: This ratio is useful for determining the ability of a company to meet its short-term liability obligations. A healthy cash situation is one in which the measurement's result is significantly higher than 100%.
Formula: Combine cash and short-term marketable securities, and divide current liabilities into the sum. If there are also marketable securities that cannot be liquidated for some time, then the deciding factor for whether to include them in the numerator is if their earliest possible liquidation date is equal to or less than the dates at which the current liabilities must be paid. The formula is:
Example: The Video Café Store, a rapidly expanding coffee bar that sells televisions to its patrons, has had continuing problems with cash flow for a number of years. Its new CFO needs a brief overview of the severity of the problem and chooses to use the cash to current liabilities ratio to provide this information. Table 4.7 shows the relevant information for the last three quarters.
The measurement for any of the three quarters indicates a considerable cash shortage, with a trend line that indicates a worsening problem. Part of the problem may be indicated by the rapidly expanding current liabilities, which are probably caused by the company's rapid rate of growth. Based on this information, the CFO schedules a meeting with the executive team to discuss a reduction in the rate of growth.
Cautions: This measurement can yield incorrect results, based on cash requirements within a reporting period. For example, a company that pays its employees once a month will presumably do so on the last day of the month, based on work performed during that month. In this common situation, the current liabilities listing in the balance sheet will not list the payroll expense, since it is incurred and paid for entirely within the month. Nonetheless, the measurement ignores this key expense item, which can mislead one into thinking that a company can easily cover its liabilities with existing cash, when in reality its unreported liabilities may far exceed the amount of cash available.
CASH FLOW TO DEBT RATIO
Description: This ratio is used to determine the amount of cash flow available to pay down fixed debt payment commitments. A ratio well above one is a sign not only of having enough cash to meet debt payment needs but also of being able to sustain more debt obligations, if necessary.
Formula: To calculate the ratio, summarize all debt and lease obligations for the reporting period and divide it into cash flow. Keep in mind that the interest expense associated with the debt has probably already been included in the derivation of the net income figure that is part of cash flow, so do not include it again in the denominator part of the ratio. The formula is:
A variation on the formula is to ignore all short-term debt payments on the grounds that the ratio is intended to measure only a company's long-term ability to meet its debt obligations. This version of the ratio is:
Example: The Saba Exploratory Consortium has requested a loan from the First Bank of the U.S. Virgin Islands so that it can purchase another deep-sea submersible for the laying of underwater phone cables. To see if the Consortium will have enough money to pay back the debt, the bank compiles Table 4.8, which has financial information for the last three years.
Though the ratio reveals that the Consortium has twice as much cash flow as there are debt payments to be met, the bank should be concerned about the continuing decline in the ratio over the past three years, because the Consortium has consistently added more debt in relation to the amount of cash it is generating. The bank may want to consider granting a loan with a short payback period so that it can get its money out quickly, before the ratio worsens further.
Cautions: The amount of debt included in the denominator of the formula can vary considerably over the measurement period as short-term debt is paid off or acquired. Also, the ratio may be rendered irrelevant if there is a sudden increase in the level of debt acquired in the future, perhaps due to an aggressive acquisition or capital budgeting expansion. Estimating debt levels over the measurement period, as well as some time into the future, is consequently the best way to develop a more accurate picture of how cash flow levels can be used to support both the actual and future estimated level of debt.
REINVESTMENT RATE
Description: The manager of a business must be prudent in determining how much of the company's cash flow to return to investors as dividends, and how much to reinvest in the business. This is a balancing act of ensuring that funds are directed toward those areas of the business that will at least earn the company's cost of capital while still keeping investors happy with an adequate payout to them. While it is not possible to measure the ability of a business to invest in the right activities, it is possible to determine at an aggregate level the proportion of cash being reinvested in the business. To do this, we use the reinvestment rate, which quantifies the percentage of cash flow being reinvested in the business.
Formula: In the numerator, add together for the measurement period the cash spent on all capital expenditures, acquisitions, research and development, and other investments in the business. In the denominator, enter for the measurement period the total amount of earnings before interest, taxes, depreciation, and amortization (EBITDA). The formula is:
Example: The operations of Underground Oil and Gas generated $50 million of EBITDA during its most recent fiscal year. The investors are clamoring for more than the $2 million in dividends that was declared during that period. The president fights back by pointing out the high reinvestment rate that Underground had during the period. It spent $15 million on drilling equipment and distribution infrastructure, $18 million on a key acquisition in a Wyoming gas field, and $7 million on research for a new horizontal drilling technique. The calculation of its reinvestment rate is:
The president of Underground has certainly made a strong case that the company is reinvesting aggressively in its business area, although the analysis does not state whether these investments will provide an adequate return on investment to the company.
Cautions: As just noted, the reinvestment rate only provides a view of the bulk amount of cash reinvested in a business—it does not provide any insights into the eventual return on investment that a business will generate from reinvested funds. In some cases in which an entire market is shrinking, it may be more prudent to stop reinvestment entirely and simply exit the business. Thus, reinvestment must be combined with judgment, and it is very difficult to measure judgment. An alternative way to consider the reinvestment rate is to track it on a trend line and see if management is altering the proportion over time; this can indicate a deliberate repositioning of the company's cash, or it could be an inadvertent change to take advantage of various business opportunities.
STOCK PRICE TO CASH FLOW RATIO
Description: One way in which investors can value a company is by the amount of cash flow it generates. For example, a reasonable valuation method is to calculate the net present value of a company's cash flows for a five-year period, which may then be used as the basis for selling the company. The ratio may also be used to determine the stock price that a company will probably achieve if it can reach a specific level of cash flow.
Formula: Multiply the existing stock price by the number of shares outstanding, and then divide the result by annual cash flow from both operations and other accounting events. The stock price and number of shares outstanding should be averages for the period over which the cash flow was generated. The formula is:
Example: The Audible Phone Company has a stock price to cash flow ratio of 3:1. The phone service provider industry, in which the Audible Phone Company operates, has a long history of generating a stock price to cash flow ratio of 6:1. With this ratio in mind, the president wants to create a budget that will generate enough cash flow to result in a stock price of $65. There are currently 13,750,000 shares outstanding. To achieve this price, what must the annual cash flow be? The calculation is:
Cautions: There are other determinants of stock price besides cash flow, although it is one of the most consistent reasons why investors will purchase a company's stock. If there are future expectations of unusually high or low sales volume, then investors will bid the stock to correspondingly high or low levels that may have nothing to do with the stock price to cash flow ratio. This ratio tends to work best in settled industries in which sales levels and corresponding cash flow levels do not change much from year to year, so investors tend to focus primarily on cash flows.
DIVIDEND PAYOUT RATIO
Description: This ratio is used by investors to determine whether a company is generating a sufficient level of cash flow to assure a continued stream of dividends to them. A ratio of less than one indicates that existing dividends are at a level that cannot be sustained over the long term.
Formula: Divide total annual dividend payments by annual cash flow. If there is a long standing tradition by the board of directors of continually increasing the amount of the dividend, then annualize the last (and presumably largest) dividend only and use the resulting figure in the numerator of the calculation. The formula is:
Example: The Williams Fund is a major investor in the Continental Gas and Electric Company. The Fund is controlled by the Williams family, whose primary concern is a long-term, predictable flow of cash from its various investments. The family is concerned that electricity deregulation may be affecting the ability of Continental Gas to pay dividends. It has collected information about Continental for the past three years, shown in Table 4.9.
The table reveals that Continental's board of directors is continuing to grant increasing amounts of dividends, despite a steady drop in cash flow. At the current pace of cash flow decline, Continental will be unable to support its current dividend rate in less than two years.
Cautions: Cash flows can vary significantly by year, so calculating this ratio for one year only may not yield sufficient information about a company's ability to pay dividends over the long term. A better approach, as was used in the example, is to run a trend line on the ratio for several years to see if a general pattern of decline emerges.