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Profitability Ratios

Both the current and quick ratios have been criticized on the ground that they do not incorporate information about the timing and magnitude of future cash flows and outflows. The following two ratios get around this problem.

  • Defensive interval measure estimates the number of days the defensive assets could service the projected daily operating expenditures of the firm. The ratio is:
    Total defensive assets

    Projected daily operating expenditures
    = Cash + Short-term investments + Accounts receivable

    Cost of goods sold + Selling and administrative expenses + Interest expense X 365 days

  • Cash ratio is a more appropriate measure when inventory and accounts receivable are of questionable value, such as with companies whose receivables are collected on an installment basis. The ratio is:
    Cash + Short-term investments Current liabilities

The traditional liquidity ratios rely exclusively on balance sheet or income statement information, not on cash flow information. To fully understand a company's viability as an ongoing concern, and analyst should calculate ratios from data on the company's cash flow statement (the statement of sources and uses of cash). This is especially true in predicting bankruptcy and financial distress. Cash flow ratios can be viewed in terms of sufficiency and efficiency. Sufficiency describes the adequacy of cash flows for meeting a company's needs; efficiency describes how well a company generates cash flow relative both to other years and to other companies.

Sufficiency Ratios

1. Cash flow adequacy:
Cash flow from operations Long-term debt paid + Purchase of assets + Dividends paid
2. Long-term debt payment:
Long-term debt payments Cash flow from operations
3. Dividend payout:
Dividends Cash flow from operations
4. Reinvestment:
Purchase of assets Cash flow operations
5. Debt coverage:
Total debt Cash flow from operations
6. Depreciation-amortization impact:
Depreciation + Amortization Cash flow from operations

Efficiency Ratios
7. Cash flow to sales:
Cash flow from operations Sales
8. Operations index:
Cash flow from operations Income from continuing operations
9. Cash flow return on assets:
Cash flow from operations Total Sales

Sufficiency Ratios

The Cash flow adequacy ratio directly measures a company's ability to generate cash sufficient to pay its debts, reinvest in its operations, and make distributions (dividends) to owners. A value of one over a period of several years shows satisfactory ability to cover these primary cash requirements. The long-term debts payment, dividend payout, and reinvestment ratios provide further insight for investors and creditors into the individual importance of these three components. When expressed as percentages and added together, these three ratios show the percentage of cash from operations available for discretionary uses.

Although a company could use cash generated from financing and investing activities to retire debt, cash from operations represents the main source of long-term funds. The debts coverage ratio can be viewed as a payback period; that is, its estimates how many years, at the current level of cash from operations, it will take to retire all debt.

The depreciation-amortization impact ratio shows the percentage of cash from operations resulting from add-backs of depreciation and amortization. Comparing this ratio to the reinvestment ratio provides insight into the sufficiency of a company's reinvestment and the maintenance of its asset base. Over several years, the reinvestment ratio should exceed the depreciation-amortization impact ratio to ensure sufficient replacement of assets at higher current cost. This ratio also can be used as an efficiency evaluation. A company would be considered more efficient if depreciation and amortization have a relatively low impact on cash operations.

.02 Efficiency Ratios

Investors, creditors, and others concerned with a company's cash flows are especially interested in the income statement and earnings measures. The
cash flow to sales ratio shows the percentage of each sales dollar realized as cash from operations. Over time, this ratio should approximate the company's return on sales. The operations index compares cash from operations to income from continuing operations. Its measures the cash-generating productivity of continuing operations. Cash flow return on assets is a measure of the return on assets used to compare companies on the basis of cash generation (as opposed to income generations) from assets.

Sufficiency and efficiency ratios are examples of information available to financial statement users from the cash flow statement. It's important to remember that, as in all ratio analysis, isolated ratios provide limited information about a single period. The ratios become more useful when computed for a period of years to determine averages and trends and when compared to industry averages.

Note: From the statement of cash flows, cash flows from operations is defined as:
Net income
Add: Noncash expenses (e.g., depreciations, amortization)
Less: Noncash revenue (e.g., amortization of deferred revenue)
Cash flow from operations

Return of common equity = Net income availability to stockholder

Average stockholder's equity


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