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Key ratios related to the cashflow statement - Views on News from Equitymaster
 
 
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  • Dec 16, 2009

    Key ratios related to the cashflow statement

    In the previous article of this series, we had taken a look at one of the components of cash flow statement - cash flow from financing activities. In this article, we shall discuss some of the key ratios relating to the cash flow statement.

    It is very common that investors give more focus and attention to balance sheets and profit and loss statements. More often than not, novice investors may ignore a company's cash flow statement on account of its relatively complex nature. This is true, when compared to the other two financial statements - balance sheet and profit and loss account.

    In the last few articles, we have tried to educate readers about the basics of a cash flow statement. Since we have completed our discussion about some of the technical terms that are found in the cash flow statement, we shall discuss some of the key ratios associated with it.

    A cash flow statement is probably the most useful too for judging or testing a company's liquidity position. In addition, it can also help in testing a company's financial health.

    We are not implying that the ratios which we discussed earlier related to the other two statements are not useful. All ratios have different usages in terms of testing a company's financial performance.

    Free cash flow per share (FCF/ Share): Free Cash Flow (FCF) is the cash earned by the company that can be actually distributed to the shareholders. It signals a company's ability to repay debt, pay dividends and buy back stock - all important undertakings from an investor's point of view.

    FCF takes into account not only the earnings of the company but also the past (depreciation) and present capital expenditures and investment in working capital. Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF due to revenue growth, efficiency improvements, cost reductions can reward investors in the future. Better free cash flows are therefore a reason for the investment community to cherish.

    On the other hand, an insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business

    An in-depth methodology would be to adjust a company's increase or decrease in net working capital (current assets less current liabilities) to the above figure. Free cash flow increases if the company manages to improve efficiency and consequently reduce the required working capital. This ratio implies the amount of free cash available per share. It is calculated as follows:

    FCF = Net Profit + Depreciation - Capital expenditure - Changes in working capital

    Therefore, FCF/share = (Net Profit + Depreciation - Capital expenditure - Changes in working capital) \ Shares outstanding

    Price to free cash flow (P/FCF) is a valuation method which allows one to compare the FCF generated per share to its share price. The higher the result, the more expensive is the stock.

    Operating cash flow ratio (OCF): OCF is calculated by dividing the cash flow from operations by the current liabilities. This ratio helps in knowing how well short term liabilities of a company are covered by the cash flow from operations. Short term liabilities in this case would be current liabilities.

    As such, operating cash flow = cash flow from operations / current liabilities

    You may have by now guessed that this ratio helps in ascertaining a company's liquidity position. But so are ratios such as the current ratio and the quick ratio, you may ask. The OCF ratio helps in assessing whether a company's operating cash flow generations are enough to cover its current liabilities. If the ratio falls below 1.0, it means that the company is not generating enough cash to meet its short term liabilities. In order to judge whether a company's OCF is out of line, one should look at comparable ratios for the company's industry peers.

    Capital expenditure ratio: This ratio helps in ascertaining how much operating cash flow a company generates as compared to the capital expenditure it incurs. It would always be better to look at the numbers for a particular period as compared to a single or particular year.

    It is calculated by dividing the cash flow from operations by the capital expenditure. Therefore:

    Capital expenditure ratio = cash flow from operations / capital expenditure

    This ratio measures the capital available for internal reinvestment and for payments on existing debt. If the ratio exceeds 1.0, it indicates that the company has enough funds to meet its capex requirements. As such, higher the value, the more spare cash the company has to service and repay debt. One will usually find lower ratios in fast growing companies on the back of high capital investments.

    Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article

     

     

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