Financial Ratios Using Cash Flow Statement Amounts
The cash flow statement, or statement of cash flows (SCF), is one of the five financial statements required by U.S. accounting rules. Since the income statement and balance sheet are prepared using the accrual method of accounting, the SCF provides the following desired information on a company's cash flows:
Cash inflows and amounts that are good for the company's cash balance. These are reported as positive amounts on the SCF.
Cash outflows and amounts that are not good for the company's cash balance. These amounts are reported in parentheses to indicate their negative effect on the company's cash.
The SCF is organized into three main sections:
- Cash flows from operating activities (or operations)
- Cash flows from investing activities
- Cash flows from financing activities
A commonly cited metric that is derived from the SCF is the amount of free cash flow.
Ratio #15 Free Cash Flow
Free cash flow is calculated from the following amounts reported on the statement of cash flows:
The total of the SCF section having the heading cash flows from operating activities. This total is described on the SCF as net cash provided by operating activities.
The amount described as capital expenditures or purchase of property, plant and equipment. This amount is reported in the SCF section having the heading cash flows from investing activities. Since this is an outflow of cash, the amount of the capital expenditures appears in parentheses.
To arrive at the amount of free cash flow, the amount of capital expenditures is subtracted from the net cash provided by operating activities.
Therefore, the formula for calculating a company's free cash flow is:
Free cash flow = net cash provided by operating activities – capital expenditures
Assume that a corporation had net cash provided by operating activities of $200,000 and had capital expenditures of $140,000. The corporation's free cash flow is calculated as follows:
Free cash flow = net cash provided by operating activities – capital expenditures
Free cash flow = $200,000 - $140,000
Free cash flow = $60,000
If a corporation considers its cash dividends paid to stockholders to be a requirement, the corporation could also subtract the required dividend amount. If the stockholders of the corporation in our example demand a constant dividend of $25,000 each year, the corporation's free cash flow will be $35,000 ($200,000 - $140,000 - $25,000).
Whether the amount of the corporation's free cash flow is adequate depends on its plans for the near future.
Many financial analysts compare 1) the amount of a corporation's net cash provided by operating activities, with 2) the corporation's earnings (net income after tax). Generally, they expect the corporation's net cash provided by its operating activities (or operations) to be greater than the corporation's earnings since depreciation expense reduced earnings but did not use cash.
If a corporation's net cash provided by operating activities is less than its earnings, it raises some concern. The sophisticated investor or financial analyst will seek to find the reason. One possibility is that customers who purchased goods with credit terms have not remitted the amounts owed. Could the reason be that the goods were not acceptable? Another possibility is the corporation made large purchases of goods, but the goods have not sold. A good analyst would be curious why the goods could not be sold.
To learn more about this important financial statement, see our topic Cash Flow Statement.
Other Financial Ratios
- Working capital
- Working capital to total assets
- Working capital turnover ratio
- Current ratio
- Quick ratio (acid test ratio)
- Accounts receivable turnover ratio
- Days' sales in accounts receivable
- Inventory turnover ratio
- Days' sales in inventory
- Fixed assets turnover ratio
- Total assets turnover ratio
- Debt to total assets ratio
- Debt to equity ratio
- Equity ratio
- Equity turnover ratio
- Times interest earned
- Profit margin after tax
- Gross profit margin
- Return on total assets
- Return on stockholders' equity
- Book value per share of common stock
- Free cash flow
- Cash flow to debt ratio
Benefits and Limitations of Financial Ratios
Benefits of Financial Ratios
Some of the benefits of financial ratios include:
Provides a way to compare a company's financial information with individual companies in the same industry or with industry averages
Provides a way for a company to monitor its key financial information over time
Provides some benchmarks to assist a company in planning for future financing needs
Limitations of Financial Ratios
While financial ratios can be beneficial, it is important to consider their limitations:
A company's financial ratios are not comparable to the ratios of companies in different industries, or with consolidated financial statements of companies operating in several industries.
Generally, financial ratios are based on a company's financial statements from a recent year. This means that the ratios are a representation of an enormous amount of past transactions (some from more than a year ago and no longer relevant).
The financial statements, and therefore the resulting ratios, reflect the cost principle. This means that some valuable assets may not be included in the company's balance sheet. Examples include brand or trade names, logos, customers' allegiance, innovative management, dominant market position, etc. which have been developed by the company (not purchased from another company).
U.S. companies (even those in the same industry) may apply accounting principles differently. For instance, one company may use the FIFO cost flow assumption for assigning costs to its inventory and its cost of goods sold, while another company uses LIFO. Some companies apply accounting principles in the most conservative way possible, while another applies them in the opposite manner.
Reviewing financial ratios derived from a few amounts appearing on past financial statements is not the same as studying the company's five required financial statements. It is also far different from reading a publicly traded corporation's Management's Discussion and Analysis (found in its annual report to the Securities and Exchange Commission, Form 10-K).
Financial ratios for accounts receivable and inventory (and others) are averages and therefore can be concealing some not-so-favorable details.
A company's efforts to improve one financial ratio can lead to adverse effects on the business and on other financial ratios.
Typically, accounting software allows for a percentage to be printed next to all of the amounts on the company's financial statements.
For instance, a company's internal income statement will contain more detail and often displays a percent next to each dollar amount. The percent is the result of dividing each amount by the amount of the company's net sales.
The company's internal balance sheet will also show more detail and often displays a percent next to each dollar amount. The percent is the result of dividing each amount by the amount of the company's total assets.
Expressing every income statement amount as a percent of net sales, and every balance sheet amount as a percent of total assets is referred to as vertical analysis.
When the financial statements are presented as percentages, they are referred to as common-size financial statements. They are "common size" since the reported percentages can be compared to the percentages for other companies even when the companies' amounts are vastly different in size.
Common-size income statement resulting from vertical analysis
You can immediately find on the following multiple-step, common-size income statement (with dollar amounts omitted) the company's gross margin of 24.0%, its profit margin before tax of 5.6%, and its profit margin after tax of 4.6%.
Common-size balance sheet resulting from vertical analysis
As you can see from the following common-size balance sheet (with amounts omitted) each item is expressed as a percent of the company's total assets.
The percentages on the common-size balance sheet (above) allow you to immediately see that the debt to total asset ratio is 62.5% (the amount of total liabilities was divided by the amount of total assets).
You can also see that stockholders' equity provided 37.5% of the total asset amount, and that the reported amount of property, plant and equipment after deducting accumulated depreciation was 43.7% of the amount of the corporation's total assets.
The percentages shown on a company's common-size balance sheet allows you to compare them to other companies' percentages even if the companies' amounts are vastly different in size.
Horizontal analysis shows a financial statement amount over a minimum of two years.
Comparative financial statements
Corporations' published financial statements are referred to as comparative financial statements since they are required to display not only the most recent year's amounts but must also display the corresponding amounts for the prior year or the prior two years. (It is rare for the external financial statements to display the percentages we discussed under vertical analysis.)
When a corporation publishes its financial statements, the following financial statements should report three columns of amounts (such as the amounts for the year 2021 and the corresponding amounts for 2020, and 2019):
- Income statement
- Statement of comprehensive income
- Statement of cash flows
- Statement of changes in stockholders' equity
The published balance sheet of a corporation must also be comparative but requires only two columns of amounts (such as the amounts as of December 31, 2021 and the corresponding amounts for December 31, 2020).
You can view comparative financial statements by doing an internet search for a corporation whose stock is publicly traded. For example, you could search for Apple form 10-K, Tootsie Roll form 10-K, etc., and then locate financial statements in the Form 10-K's table of contents. (Form 10-K is part of the corporation's annual filing with the SEC. The corporation's 10-K is also accessible by using the corporation's link entitled Investor Relations.)
Trend analysis or time series analysis
When horizontal analysis involves comparing amounts from more than two years, it may be referred to as trend analysis (or time series analysis).
The following table is an example of a trend analysis in which the amounts for the most recent five years are compared: