Cash-based accounting ratios - breaking the silence
by John Richard Edwards
01 Oct 2000
The merits of cash based financial reporting ; for example, it is based
principally on facts rather than problematic accounting measurements ;
have been known for many years. However, it was not until 1990 (revised 1996) that the Accounting Standards Board made the publication of Cash Flow Statements (FRS 1) a standard requirement for UK companies. FRS 1 tells us that the ;cash flow statement in conjunction with a profit and
loss account and balance sheet provides information on financial position and performance as well as liquidity, solvency and financial adaptability;. Wise words, but what do they mean?
The usefulness of financial statements is enhanced by an examination of
the relationship between them; also by comparisons with previous time periods, other entities and expected performance. Value can be further added through the calculation and interpretation of accounting ratios. An examination of accounting textbooks and the pages of accounting
periodicals reveals an enthusiasm for rehearsing the potential of ;accounting ratios; demonstrated through calculations of the net
profit margin, return on capital employed, current ratio and a host of other ;traditional; measures based on the contents of the profit and loss and balance sheet. But what about the cash flow statement? We have
seen that its publication was required by the ASB in order to improve the informative value of published financial information. Indeed, some say it is the most important financial statement. One based on ;hard
facts; which has helped prevent financial machinations such as those that are believed to have occurred at companies such as Polly Peck in the 1980s.
The lack of attention to cash flow-based ratios in accounting textbooks
is particularly surprising given their acknowledged role in credit rating
assessments and in the prediction of corporate failure. In these and other contexts, the traditional ratios suffer from the same defect as the financial statements (the profit and loss account and balance sheet) on which they are based. Such ratios are the result of comparing figures
which have been computed using accounting conventions and
;guestimations;. Given the difficulty of deciding the length of the period over which a fixed asset should be written off, whether the tests which justify the capitalisation of development expenditure have been satisfied, the amount of the provision to be made for claims under a manufacturer;s twelve month guarantee (to give just a few examples), ratios based on such figures are also bound to have limited economic
significance. This is not to suggest that the traditional ratios are irrelevant. Clearly this is not so, as they reveal important relationships and trends that are not apparent from the examination of individual figures appearing in the accounts. However, given the fact
that cash flow ratios contain at least one element that is factual (the numerator, the denominator or both), their lack of prominence in the existing literature is puzzling.
Some recognition of cash flow ratios
The importance of cash flow ratios was dramatically demonstrated, early on, by W. H. Beaver whose 1966 study showed that the most effective predictor of corporate failure was the ratio of cash flow to total debt. Indeed, one of his most surprising findings was that the current ratio
proved to be one of the least useful ratios in predicting impending collapse. The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role within the business. Colourfully described as a company;s ;life-blood;, a strong
cash flow will enable a business to recover from temporary financial problems whereas future negative cash flow will cause even an apparently sound enterprise to move towards liquidation. Expressing the importance of cash differently: a company which descends into a loss-making position
often succeeds in making a comeback; one which runs out of cash is unlikely to have a second chance.
Another US-based writer, Yuji Ijiri, has noted the paradox between the way in which investment decisions are made by business and other entities and the way in which the results of those decisions are evaluated. The principal focus for informed investment decisions is cash flows, whether
the capital project appraisal method is ;payback; or one of the more
sophisticated discounted cash flow-based techniques, namely ;net
present value; and ;internal rate of return;. Turning to performance
evaluation, however, the emphasis usually shifts to techniques such as return on investment. The inconsistency between the two approaches is highlighted by the use of depreciation cost allocation for computing ROI; a calculation which has no place whatsoever in the above project appraisal methods. Ijiri persuasively argues, therefore, the importance of making
project appraisal and performance evaluation consistent.
In the remainder of this paper are presented:
; ratios which link the cash flow statement with the two other principal financial statements;
; ratios and percentages based entirely on the contents of the cash flow statement.
To illustrate the calculations, the results of Tamari plc for 1998 and 1999 appear in Figure 1. For each ratio is presented both the calculation and a discussion of its significance. Inevitably, there will be some overlap in the messages conveyed by the various ratios presented. This may be due to similarities in the nature of the calculations or to the
fact that the results of just one company are used for illustration purposes. The application of the same ratios to different financial facts might well yield additional valuable insights.
Ratios which link the cash flow statement with the two other
principal financial statements
Cash flow from operations to current liabilities
Cash flow from operations to current liabilities
= Net cash flow from operating activities x 100
Average current liabilities
Net cash flow from operating activities is taken directly from the cash flow statement published to comply with FRS 1. Average current
liabilities are computed from the opening and closing balance sheet.
This ratio examines the liquidity of the company by providing a measure
of the extent to which current liabilities are covered by cash flowing into the business from normal operating activities. The ratio is thought to possess some advantage over balance sheet-based ratios such as the
liquidity ratio as a measure of short-term solvency. This is because
balance sheet ratios are based on a static positional statement (the ;instantaneous financial photograph;) and are therefore subject to
manipulation by, for example, running down stock immediately prior to the year end and not replacing it until the next accounting period. Balance sheet based ratios may alternatively be affected by unusual
events which cause particular items to be abnormally large or small. In either case, the resulting ratios will not reflect normal conditions.
Cash recovery rate
Cash recovery rate (CRR) =
Cash flow from operations x 100
Average gross assets
Cash flow from operations is made up of ;net cash flow from operating
activities; together with any proceeds from the disposal of long-term
assets. Gross assets is the average gross value of the entity;s assets.
Assets are required to generate a return which is ultimately, if not immediately, in the form of cash. The CRR is, therefore, a measure of the rate at which the company recovers its investment in fixed assets. The quicker the recovery period, the lower the risk. You may have noticed that the CRR is thus the reciprocal of the pay back period used for capital
project appraisal purposes assuming projects have equal (or roughly equal) annual cash flows.
Cash flow per share
Cash flow per share =
Weighted average no. of shares
There are two versions of cash flow reflecting different applications
of the cash flow per share calculation:
Version I: Where cash flow = operating profit plus non-cash adjustments
such as depreciation and amortisation of fixed assets.
This version provides a measure of the amount of cash that a company generates from operating activities, exclusive of working capital changes. It draws attention to the important role of non-cash adjustments
in this process. A company may be operating at a low profit or even a loss and still be capable of generating a significant amount of ;cash
Version II: Where cash flow = net cash flow from operating activities +/; returns on investments and servicing of finance ; taxation and
dividends paid. This version recognises the fact that cash is available for long-term investment only after working capital requirements, tax and dividends have been met. It indicates the ability of the company to fund long-term investment out of resources generated internally.
In either case, the number of shares used as the denominator should be
the weighted average of the number in issue during the year. However, the average only needs to be weighted if there is an issue of shares involving an inflow of resources; in the case of a bonus issue (where no extra resources are generated), the number of shares post bonus issue
should be used without weighting and the number in issue the previous year made comparable.
Capital expenditure per share
Capital expenditure per share =
Capital expenditure x 100
Weighted average no. of shares
Where: Capital expenditure = net investment (purchases less sales proceeds) in fixed assets.
This ratio, in conjunction with cash flow per share (Version II) can be
used in order to obtain a broad indication of whether a business is a net generator of cash or whether it is ;cash hungry;.
Debt service coverage ratio
Debt service coverage ratio (DSCR) =
annual debt repayments and interest
Where: EBITDA = Earnings before interest, tax, depreciation and amortisation.
The purpose of this ratio is to help assess the ability of a company to
meet debt repayments and interest out of cash flow generated from operations. A feature of this ratio is that it is forward looking with the denominator representing expected future cash flows. (If available, the numerator