Financial Ratios

The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense.

The statement of cash flows is a relatively new financial statement in comparison to the income statement or the balance sheet. This may explain why there are not as many well-established financial ratios associated with the statement of cash flows.

We will use the following cash flow statement for Example Corporation to illustrate a limited financial statement analysis:

Example Corporation Statement of Cash Flows For the Year Ended December 31, 2006 Cash Flow from Operating Activities: Net Income $23,000  Add: Depreciation Expense 4,000  Increase in Accounts Receivable (6,000) Decrease in Inventory 9,000  Decrease in Accounts Payable    (5,000) Cash Provided (Used) in Operating Activities   25,000  Cash Flow from Investing Activities Capital Expenditures (28,000) Proceeds from Sale of Property     7,000  Cash Provided (Used) by Investing Activities  (21,000) Cash Flow from Financing Activities: Borrowings of Long-term Debt 10,000  Cash Dividends (5,000) Purchase of Treasury Stock    (8,000) Cash Provided (Used) by Financing Activities    (3,000) Net Increase in Cash 1,000  Cash at the beginning of the year     1,200  Cash at the end of the year $  2,200

Financial Ratio		How to Calculate It	What It Tells You
Free Cash Flow	= = =	Cash Flow Provided by Operating Activities – Capital Expenditures $25,000 – $28,000 ( $3,000)	This statistic tells you how much cash is left over from operations after a company pays for its capital expenditures (additions to property, plant and equipment). There can be variations of this calculation. For example, some would only deduct capital expenditures to keep the present level of capacity. Others would also deduct dividends that are paid to stockholders, since they are assumed to be a requirement.

The cash flow from operating activities section of the statement of cash flows is also used by some analysts to assess the quality of a company's earnings. For a company's earnings to be of "quality" the amount of cash flow from operating activities must be consistently greater than the company's net income. The reason is that under accrual accounting, various estimates and assumptions are made regarding both revenues and expenses. When it comes to cash, however, the money is either in the bank or it isn't.

(To learn more about the statement of cash flows, go to Explanation of Cash Flow Statement, Drills for Cash Flow Statement, and Crossword Puzzle for Cash Flow Statement.)

Because the material covered here is considered an introduction to the topic of financial ratios, there are many complexities not presented. You should always consult with an accounting professional for assistance with your own specific circumstances.

Where Do I Go Next?

• Clear explanations for 27 accounting topics
• Interactive drills for all topics
• 16 accounting exams
• 200+ answers to visitors' questions
• Crossword puzzles and word scrambles
• Dictionary of 1,000+ accounting terms
• Printable PDF downloads
• Accounting forum