Cash flow performance and coverage ratios

Which ratios use the cash flow statement?

Eleven, in two families. They put companies, and whole industries, side by side on the cash they generate instead of the profit they report.

Cash flow ratioseach one asks how much operating cash backs something

• Performance (profitability) Memorize CFO per unit of…
  • Cash flow to revenue CFO ÷ net revenue
  • Cash return on assets CFO ÷ average total assets
  • Cash return on equity CFO ÷ average equity
  • Cash to income CFO ÷ operating income
  • Cash flow per share (CFO − preferred dividends) ÷ common shares
• Coverage (solvency and ability to pay) Memorize CFO against what it must pay for
  • Debt coverage CFO ÷ total debt
  • Interest coverage (CFO + interest + taxes paid) ÷ interest paid
  • Reinvestment CFO ÷ cash paid for long-term assets
  • Debt payment CFO ÷ long-term debt repaid
  • Dividend payment CFO ÷ dividends paid
  • Investing and financing CFO ÷ all investing and financing outflows

Performance ratios divide CFO by something that earns it. Coverage ratios divide CFO by something it has to pay for. All are better higher.

How do the performance ratios work?

Each divides operating cash flow by a measure of scale. They are the cash-based cousins of margins and returns: read each as “operating cash generated per unit of…”.

$$\frac{CFO}{\text{net revenue}}$$

Cash flow to revenue tells you how many cents of operating cash each dollar of sales brings in.

$$\frac{CFO}{\text{average total assets}}$$

Cash return on assets is the cash version of ROA: how hard the asset base works to produce operating cash. The cash return on equity divides by average shareholders’ equity instead.

$$\frac{CFO}{\text{average shareholders' equity}}$$

$$\frac{CFO}{\text{operating income}}$$

Cash to income asks how well operating profit turns into operating cash. A ratio that keeps falling while profit rises, or sits well below peers, is an accrual warning.

$$\frac{CFO - \text{preferred dividends}}{\text{common shares outstanding}}$$

Cash flow per share belongs only to common shareholders, so preferred dividends come off first.

How do the coverage ratios work?

Each asks whether operating cash is enough to pay for something. The only one with a longer numerator is interest coverage.

$$\frac{CFO}{\text{total debt}}$$

The debt coverage ratio is a leverage and risk gauge: the lower it is, the heavier the debt relative to the cash available to service it. Its inverse is the number of years of CFO needed to repay the debt.

$$\frac{CFO + \text{interest paid} + \text{taxes paid}}{\text{interest paid}}$$

Cash interest coverage adds interest and taxes back because both were paid out of cash before CFO was struck. The numerator is then the cash available to meet interest, before interest and tax.

$$\frac{CFO}{\text{cash paid for long-term assets}}$$

The reinvestment ratio asks whether operations alone paid for this year’s long-term asset purchases. The debt payment ratio does the same for long-term debt repayments, and the dividend payment ratio for dividends.

$$\frac{CFO}{\text{cash paid for long-term debt repayment}}$$

$$\frac{CFO}{\text{dividends paid}}$$

$$\frac{CFO}{\text{cash outflows for investing and financing}}$$

The investing and financing ratio is the widest test: can operating cash pay for all asset purchases, debt repayments and distributions together?

What changes under IFRS?

Reported CFO depends on where the company put interest and dividends, so adjust before comparing. Two notes matter for the ratios under International Financial Reporting Standards (IFRS).

• Interest coverage. If interest paid is in financing, it was never deducted from CFO. Do not add it back to the numerator. (Taxes paid are still added back.)
• Cash flow per share. If total dividends paid are shown in operating activities, add them back to CFO first, then subtract preferred dividends.

Exam tip The interest coverage answer does not depend on classification once you adjust. Seabright with interest in financing reports CFO of 920. Adding taxes only gives (920 + 200) ÷ 120 = 9.3×, the same as before.

How do you interpret the ratios?

Higher is better, and 1 is the break-even for the ratios that compare CFO with a payment. Below 1, the item was not covered by operations alone and someone else filled the gap.

Use the ratios in time and against peers. A falling cash to income ratio over several years, with profit rising, is the accrual warning the reporting quality module develops. Cash-based interest coverage complements the usual version based on earnings before interest and taxes (EBIT), because it reflects the cash that really arrives.

Go deeper Why cash-based coverage complements EBIT coverage

EBIT-based interest coverage divides an accounting profit by interest. A company can show a comfortable EBIT multiple while its customers are slow to pay, in which case the cash available to meet interest is smaller than the profit suggests. The cash version asks the question lenders actually care about: is there cash to make the payment? Credit analysts look at both.

Go deeper Why a falling cash to income ratio is an accrual warning

Operating income is built on accruals: revenue recognized when earned and expenses when incurred. CFO strips out the timing. The level of the ratio depends on the business (CFO adds back depreciation but is after interest and taxes, while operating income is before them), so judge it by its trend and against peers. When the ratio keeps sliding while operating income grows, profit is being recognized faster than cash is collected, through receivables, inventory or capitalized costs. That is why the ratio reappears in the discussion of reporting quality.