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Measuring company health via cash flow ratios Your lender may place a higher value on cash flow than on profits and net worth To most business owners, balance sheets and income statements may be the most familiar types of financial reports; but they're usually not the most reliable, especially in measuring liquidity. Your balance sheet is little more than a snapshot that shows your company's financial condition on a given date. Your income statement may skew your profit picture by including a variety of non-cash allocations. Your most reliable business barometer - the financial statement that shows how much cash is available for operations and investments - is usually your cash flow statement, which reveals the all-important cash flow ratios that investors, lenders and analysts hold so dear. Cash flow ratios test how much cash was generated over a period of time and compare that total to near-term obligations, giving a dynamic picture of what resources the company can muster. In contrast, current and quick ratios simply indicate how much available cash the company had on a single date. The most useful cash flow ratios fall into two general categories. The first group consists of ratios that test for solvency and liquidity:
The second group of ratios indicates the viability of a business as a going concern. It includes "cash to capital expenditures" (CE) and "cash to total debt" (TD) ratios. Solvency. Operating cash flow (OCF) ratios measure a company's ability to generate resources to meet current liabilities. OCF ratios vary drastically from industry to industry. Labor-intensive businesses tend to produce high OCF, while the OCF of capital-intensive companies is relatively low. Funds flow coverage (FFC) ratios show a company's ability to cover unavoidable expenditures. In contrast to OCF, the FFC ratio excludes cash paid out for interest and taxes. A prospective lender can use the FFC ratio to evaluate the risk that a borrower will default on its most immediate financial commitments: interest payments, short-term debt, and preferred dividends. An FFC ratio of 1-to-1 indicates that a company can meet those commitments, but with little or no cushion. The greater the FFC ratio, the greater the company's capacity to reinvest cash for growth. Cash interest coverage (CIC) ratios indicate a company's ability to meet interest payments. A highly leveraged company will have a low CIC, while a very liquid company will have a high CIC. A company with a CIC less than 1-to-1 is a high default risk. Cash current debt coverage (CDC) ratios show a company's ability to repay its current debt. The current debt ratio measures a company's ability to carry debt comfortably. The higher the ratio, the higher the comfort level; however, as is the case with most other ratios, as long as the company isn't insolvent, the right level depends on industry characteristics. Financial health. Lenders, investors and credit-rating agencies are very concerned with questions about a company's ability to meet its operational commitments and to finance growth.
These and other questions can be answered by the second category of cash flow ratios, which assess a company's strength on an ongoing basis. Capital expenditure (CE) ratios measure the capital available for internal reinvestment and for payments on existing debt. When this ratio exceeds 1-to-1, the company can meet its capital investment, with some left over to meet debt requirements. The higher the ratio, the more spare cash the company has to service and repay debt. Total debt (TD) ratios indicates the length of time it will take to repay a debt, assuming all cash flow from operations is used for debt repayment. The lower the TD, the lower the financial flexibility and the higher the potential for default. Conclusion. Familiarity with the cash flow ratios described in this article will help you understand lender scrutiny of financial data beyond that contained in your income statement and balance sheet. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |
