The Power of Cash Flow Ratios
CASH FLOW RATIOS ARE MORE RELIABLE indicators of liquidity than balance sheet or income statement ratios such as the quick ratio or the current ratio. LENDERS, RATING AGENCIES AND WALL STREET analysts have long used cash flow ratios to evaluate risk, but auditors have been slow to use them. SOME CASH FLOW RATIOS COMPARE THE RESOURCES A company can muster with its short-term commitments. OTHER CASH FLOW RATIOS MEASURE A COMPANYS ability to meet ongoing financial and operational commitments. THERE IS NO CONSENSUS ON THE DEFINITION OF NET free cash flow, although the authors suggest taking off-balance-sheet financing into account. AUDITORS CAN USE THE INSIGHTS uncovered by cash flow ratios to spotlight potential problem areas, thus helping them plan their audits more effectively.
JOHN R. MILLS, CPA, PhD, is a professor in the Department of Accounting and CIS at the University of Nevada, Reno. His e-mail address is firstname.lastname@example.org. Mills experience includes auditing and consulting in the gaming industry.
JEANNE H. YAMAMURA, CPA, PhD, is an assistant professor in the accounting and CIS department at the university's Reno campus. Her e-mail address is email@example.com. Yamamura worked as an auditor overseas, including a stint in Papua, New Guinea.
To fully understand a company's viability as an ongoing concern, an auditor would do well to calculate a few simple ratios from data on the clients cash flow statement (the statement of sources and uses of cash). Without that data, he or she could end up in the worst possible position for an auditor—having given a clean opinion on a client's financials just before it goes belly up.
When it comes to liquidity analysis, cash flow information is more reliable than balance sheet or income statement information. Balance sheet data are static—measuring a single point in time—while the income statement contains many arbitrary noncash allocations—for example, pension contributions and depreciation and amortization. In contrast, the cash flow statement records the changes in the other statements and nets out the bookkeeping artifice, focusing on what shareholders really care about: cash available for operations and investments.
For years, credit analysts and Wall Street barracudas have been using ratios to mine cash flow statements for practical revelations. The major credit-rating agencies use cash flow ratios prominently in their rating decisions. Bondholders—especially junk bond investors—and leveraged buyout specialists use free cash flow ratios to clarify the risk associated with their investments.
That's because, over time, free cash flow ratios help people gauge a company's ability to withstand cyclical downturns or price wars. Is a major capital expenditure feasible in a tough year? If the last time total cash got a hair below where it is now the company's capital structure had to be revamped, the auditor should treat the deficient value like a loud buzzer.
Many auditors and, to a lesser extent, corporate financial managers have been slow to learn how to use cash flow ratios. In our experience, auditors traditionally use either a balance sheet or a transaction cycles approach. Neither approach emphasizes cash or the statement of cash flows. While auditors do use the cash flow statement to verify balance sheet and income statement accounts and to trace common items to the cash flow statement, their use of ratios for cash-related analysis has been limited to the current ratio (current assets/current liabilities) or the quick ratio (current assets less inventory/current liabilities). According to an informal survey of Big 5 and other national accounting firms, even now their audit procedures have not changed in ways that take advantage of the information presented in the cash flow statement, even though that statement has been required for over a decade.
The value of cash flow...
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