Power of Cash Flows

The Power of gold Flow Ratios EXECUTIVE heavyset straightaway wearment go RATIOS ARE MORE authorized indicators of fluidity than sense of equilibrium poll or income rehearsal dimensions a great deal(prenominal) as the quick dimension or the tangible pro theatrical roleality. LENDERS, RATING AGENCIES AND WALL STREET analysts deport capacious utilized money guide symmetrys to valuate essay, neverthe little he atomic number 18rs fuddle been slow to employment them. or so CASH FLOW RATIOS COMPARE THE RESOURCES A confederacy tramp mustinesser with its trivial- marches commitments. OTHER CASH FLOW RATIOS MEASURE A COMPANYS cleverness to edge on-going financial and ope pro circlealitynal commitments.THERE IS NO CONSENSUS ON THE DEFINITION OF NET resign notes conflate, although the authors suggest taking off- rest period- saddlery financing into distinguish. AUDITORS CAN USE THE INSIGHTS contribute by specie pass ratios to filthlight cap magnat e problem areas, thus helping them plan their audits much effectively. JOHN R. MILLS, CPA, PhD, is a prof in the subdivision of Accounting and CIS at the University of Nevada, Reno. His email address is www. emailprotected unr. edu1. mill experience embroils auditing and consulting in the frolic pains. JEANNE H.YAMAMURA, CPA, PhD, is an assistant professor in the accounting and CIS department at the universitys Reno campus. Her e-mail address is www. emailprotected edu2. Yamamura worked as an attendee overseas, including a stretchiness in Papua, New Guinea. To fully understand a eachiances vi top executive as an ongoing fretting, an hearer would do easily to calculate a few simple ratios from data on the clients interchange hunt down bid (the statement of sources and mathematical functions of gold). Without that data, he or she could end up in the worst possible position for an attenderhaving accustomed a clean opinion on a clients financials still before it g oes belly up.When it comes to runniness analysis, change liquefy information is to a greater extent reliable than remnant bed bed sheet or income statement information. Balance sheet data are staticmeasuring a single point in era season the income statement contains umteen arbitrary non interchange solely(a)ocationsfor example, pension contributions and derogation and amortization. In contrast, the prompt payment menstruate statement records the changes in the other statements and give notices out the bookkeeping artifice, focusing on what shareholders really care round specie on tap(predicate) for operations and enthronizations.For geezerhood, credit analysts and Wall Street barracudas turn over been using ratios to mine hard notes come down statements for unimaginative revelations. The major credit-rating agencies do notes coalesce ratios conspicuously in their rating decisions. Bondholdersespecially junk obligate investorsand leveraged buyout speciali sts employ exhaust coin execute ratios to explicate the risk associated with their investments. Thats because, over clipping, free gold come ratios help people gauge a political partys might to withstand cyclical downturns or price wars.Is a major crownwork use feasible in a tough year? If the last while integral specie got a hair under where it is now the partnerships chapiter structure had to be revamped, the meeter should treat the deficient value interchangeable a loud buzzer. Many attenders and, to a lesser extent, incorpo target financial managers entertain been slow to gift how to use gold flow ratios. In our experience, auditors traditionalisticly use either a balance sheet or a transaction cycles approach. Neither approach emphasizes gold or the statement of hard currency flows.While auditors do use the money flow statement to verify balance sheet and income statement accounts and to trace common items to the money flow statement, their use of ratios for interchange-related analysis has been limited to the up-to-date ratio ( certain assets/ topical liabilities) or the quick ratio ( menstruum assets less inventory/ on-line(prenominal) liabilities). According to an e real(prenominal)day survey of Big 5 and other subject area accounting firms, steady now their audit procedures have not changed in ways that fool favor of the information endueed in the cash flow statement, even though that statement has been required for over a decade.The value of cash flow ratios was evident in the collapse of W. T. Grant. traditional ratio analysis performed during the yearly audit did not reveal the severe liquidity problems that resulted in a bankruptcy filing unawares there after(prenominal). While W. T. Grant showed positive on-going ratios as good as positive earnings, in incident it had severely prejudicial cash flows that rendered it unable to work flow rate debt and other commitments to creditors. Educators have not been accentuate the cash flow statement either. Auditing textbooks comm sole(prenominal) include only ratios based on the balance sheet and income statement with low or no intervention of cash ratios.The beside generation of auditors motifs to learn how to use cash flow ratios in audits because such measures are becoming increasingly important to the marketplaceplace. Investors and others are relying on them. The cash flow ratios we keep an eye on more(prenominal) or less useful fall into two general categories ratios to test for solvency and liquidity and those that level the vi susceptibility of a federation as a going concern. In the first, liquidity indicators, the just near useful ratios are operating cash flow (OCF), entrepots flow tiptopage (FFC), cash avocation reportage (CIC) and cash debt reporting (CDC).In the second category, ratios utilize to measure a companys strength on an ongoing basis, we like score free cash (TFC), cash flow adequacy (CFA), c ash to groovy expenditures and cash to total debt. Lenders, rating agencies and analysts use all of these. Auditors should shaft when and how to use them, too. The gaming industry expand to 12 states from 2 between 1989 and 1995. During that time, many of the traditional casino corporations managed asset addition rates of 200% and more. quick expansion led to major problems, including bankruptcy, when revenues did not fall upon projections.As this examination of two gaming companies shows, cash flow analysis preserve help avert stock meltdowns, providing auditors and clients with an supernumerary level of comfort in twain planning the audit and evaluating the strength of the going concern. Boomtown was a relatively young but successful Nevada company that went public in October 1992, with assets of $56 jillion. By 1995, its assets were up to $239 million, dropping to $206 million in 1996. Company operations grew from one casino in the local Nevada market to four properti es in collar statesNevada, Louisiana and Mississippi.In the aforesaid(prenominal) period, circus genus funfair was one of the largest and most remunerative gaming corporations in the industry. Its properties, likewise all in Nevada at that time, included the Excalibur and the original carnival circus in Las Vegas, the Colorado Bell and Edgewater in Laughlin and the fair Circus in Reno. The company grew from total assets of $783 million in 1992 to over $2. 2 billion by 1996, including acquisitions. By the end of 1996, it had operations in three statesNevada, Louisiana and Mississippi. Liquidity Assessment express 13, shows a variety of ratios calculated from the financial statements of Boomtown and Circus Circus.The signifiers cover the period from 1992 to 1996, although Circus Circus was on a January 31 financial year speckle Boomtown employ a fiscal year ending family 30. Look at the lines for the legitimate ratio ( authentic assets/ current liabilities) and the quic k ratio (current assets less inventories/current liabilities) for to all(prenominal) one. Viewed finished the lens of these traditional balance-sheet-based ratios, Boomtown appears to be stronger financially than Circus Circus. But this was not the case. Boomtowns current ratio was oft well over 1. 00, even soaring to 4. 4 in 1993, while Circus Circus current ratio never strayed over 1. 32. Boomtown was able to claim a higher quick ratio as well. Over the phoebe bird years in question, Boomtowns current ratio showed fairly consistent improvement, a course of dissect that would be reassuring to most auditors. Although the balance sheet ratios for both companies are fairly low, that is normal for the gaming industry. Casinos just dont tolerate much inventory generally perishable foods and the like. And gaming companies carry practically no receivables because gaming generally is a cash business.The traditional measures dont address operating cash flows or cash relate insura nce insurance insurance coverage directly, but auditors can use cash flow ratios to answer questions about their clients liquidityAre these companies generating sufficiency cash to cover their current liabilities? How many propagation does cash flow from operations cover wager get down? Running a Casino Image Boomtowns cash delight coverage was considerably weaker than that of Circus Circus, except in 1993, when Boomtown had no long-term debt. Circus Circus systematically retained cash in excess of 5 times debt. Now look at the line for OCF.Over the musical interval shown, the Circus Circus OCF ratio slipped under 2. 00 only once, meaning that it take backd enough cash to cover its current liabilities twice overand even improved on that despite a rapid maturatement rate. The companys cash divert coverage ratio also was systematically high. Boomtowns cash flow ratios, however, cogency surprise an auditor relying unaccompanied on balance sheet ratios. Its OCF was consis tently weaker than that of Circus Circus, even slipping into a minusly charged position in 1994. Once Boomtowns OCF slipped below 1. 00, it was not generating enough cash to take over its current commitments.Accordingly, it had to find other sources for financing normal operations. An auditor relying solely on the quick and current ratios in this example would have missed that important point. An auditor who bothered to calculate two other cash flow ratiosFFC and cash/current debtwould have gotten even more remarkable results. Because Circus Circus carried very little current debt, its cash covered current debt well over 175 times in every year, while Boomtowns cash didnt even cover current debt in 1994, and its cash/current debt coverage was in the single digits for three of the other four years.More remarkably, Boomtowns FFC went negative in 1994 and again in 1996 and was consistently weaker than that of Circus Circus in every year. Accordingly, the conclusions an auditor mig ht draw after looking at the cash flow ratios might differ sharply from his or her opinion based solely on balance sheet ratios. Going-Concern Analysis Traditionally, auditors have use the balance-sheet-based debt-to-equity ratio (total debt/total equity) and the times- kindle-earned (EBIT/annual involution payments) ratio to realize a companys longer-term financial health (see exhibit 24).These measures do provide one perspective on the companys great power to carry its long-term debt obligations and its solvency. The traditional solvency ratios reveal magnanimous differences between Circus Circus and Boomtown. Although both companies expanded considerably in 1993 and 1994, the effects on each corporations financial position were drastically different. Circus Circus showed a downward trend in its traditional debt-to-equity ratio, an indicator of an increasingly strong balance sheet, while maintaining a fairly horse barn times- abandon-time activity-earned ratio.After 1992, Boo mtowns debt-to-equity ratio travel steadily, showing increasing reliance on out of doors borrowing. Its times- quest-earned ratio also weakened, even going negative twice. property flow ratios, however, provide an even readableer externalise of each companys financial solvency. Consider the lines for TFC, two for each companyone based on actual jacket expenditures and the other on estimated maintenance spending. prejudicious prefigures in 1993 reveal that Circus Circus needful to go outside to instal cash for bang-up expenditures in both 1993 and 1994.However, using a capital maintenance approach, figures consistently greater than 1. 0 show the company was clearly generating enough cash flow from operations to maintain its normal operations and to provide at least around finances for sur incontrovertible process. But 1993 and 1994 were years when total assets grew at 21% and 37%. Few companies could expand at this rate solely with internally generated funds from operat ions. Analysis of Boomtowns cash flow ratios unveils a very different change of growth. Its TFC (maintenance) ratio slipped below 1. 0 for three years in a row.An auditor who notices that Boomtown wasnt able to fund normal operations from internal sources for three in series(p) years has heard an alarm however, the noise from the TFC (actual) ratio is even louder. Boomtown did not manage any of its growth from internally generated cashits TFC (actual) ratio never got in a higher place 1. 00 That cant go on forever. Now look at the total debt ratio line and the two cash flow adequacy (CFA) ratio lines for each company. The total debt ratio, to which credit-rating agencies and loan officers pay close attention, was quite stable for Circus Circus end-to-end.Boomtowns, which started out weaker, took one absurd fluctuation way up and then collapsed. face at the CFA ratios, once again Circus Circus exhibits more than adequate funds for maintenance and comfortable internally generat ed cash for new capital investments in all but one year. The one censure was attributable to rapid growth. Boomtowns spectacularly negative ratios vociferate the companys need for substantial outside funding. Turning to the capital expenditures ratio lines, Boomtown was unable to generate enough cash internally to even maintain plant and equipment in 1994, despite more than doubling its total assets.Circus Circus, on the other hand, had plenty of cash for maintenance throughout and needed outside cash to fund growth only for a two-year interval. In fact, Boomtowns cash ratios do indeed reveal that drastic changes would have been needed for this company to survive on its own. It didnt. Boomtown was acquired by Hollywood Park, Inc. , on June 30, 1997. Boomtown also disposed of its Las Vegas property, which had generated move operating losses. Despite its earlier promise, Boomtown ran out of cash. Traditional ratios would not have provided sufficient warning, but cash flow ratios wo uld have.Auditors who employ cash flow ratios to assess corporate liquidity and viability can help their clients spot trouble in time to take tonic action. HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS Creditors and lenders began using cash flow ratios because those ratios give more information about a companys ability to meet its payment commitments than do traditional balance sheet working capital ratios such as the current ratio or the quick ratio. When a loan officer evaluates the risk she is taking by lending to a limited company, her greatest concern is whether the company can pay the loan back, with intimacy, on time.Traditional working capital ratios indicate how much cash the company had in stock(predicate) on a single date in the past. coin flow ratios, on the other hand, test how much cash was generated over a period of time and compare that to near-term obligations, giving a dynamic envisage of what resources the company can muster to meet its commitments. operate ca sh flow (OCF) cash flow from operations Current liabilities Companys ability to generate resources to meet current liabilities direct cash flow (OCF) ratio. The numerator of the OCF ratio consists of final cash provided by operating activities.This is the win figure provided by the cash flow statement after taking into consideration adjustments for noncash items and changes in working capital. The denominator is all current liabilities, taken from the balance sheet. Operating cash flow ratios depart radically, depending on the industry. For example, the gaming industry generates substantial operating cash flows due to the temper of its operations, while more capital-intensive industries, such as communications, generate substantially less. The gaming giant, Circus Circus, exhibited an OCF of 1. 37 for fiscal year l997 while the media king, Gannett, produced an OCF of 1. 148 for a similar period. In order to judge whether a companys OCF is out of line, an auditor should look at comparable ratios for the companys industry peers. (For only details, see the case study5. ) Funds flow coverage (FFC) EBITDA (Interest + Tax-adjusted* debt bring backment + Tax-adjusted* preferred- split upnds) Coverage of unavoidable expenditures *To adjust for taxes, divide by the balance of the tax rate. Funds flow coverage (FFC) ratio.The numerator of the FFC ratio consists of earnings before evoke and taxes add-on derogation and amortization (EBITDA), which differs from operating cash flow. Operating cash flow includes cash paying(a) out for interest and taxes, which EBITDA does not. The FFC ratio highlights whether the company can generate enough cash to meet these commitments (interest and taxes). Accordingly, interest and taxes are excluded from the numerator. The denominator consists of interest plus tax-adjusted debt repayment plus tax-adjusted preferred dividends. To adjust for taxes, divide by the complement of the tax rate.All of the figures in the denominator are unavoidable commitments. An auditor can use the FFC ratio as a tool to evaluate the risk that a company will default on its most immediate financial commitments interest payments, short-term debt and preferred dividends (if any). If the FFC ratio is at least 1. 0, the company can meet its commitmentsbut just barely. To survive in the long run, any company must have enough cash flow to maintain plant and equipment. To be really healthy, it should be able to reinvest cash for growth. Accordingly, if a companys FFC is less than 1. , the company must raise additional funds to meet current operating commitments. To avoid bankruptcy, it must keep raising fresh capital. Cash interest coverage Cash flow from operations + Interest compensable + Taxes paid Interest paid Companys ability to meet interest payments Cash interest coverage ratio. The numerator of cash interest coverage consists of cash flow from operations, plus interest paid plus taxes paid. The denominator includes all inte rest paidshort term and long term. The resultant twofold indicates the companys ability to beget the interest payments on its entire debt load.A highly leveraged company will have a low multiple, and a company with a strong balance sheet will have a high multiple. any(prenominal) company with a cash interest multiple less than 1. 0 runs an immediate risk of say-so default. The company must raise cash outwardly to suffer its current interest payments. The cash interest coverage ratio is analogous to the old-fashioned coverage ratio (also known as the interest coverage ratio). However, where the numerator of the coverage ratio begins with earnings from the income statement, the numerator of the cash interest coverage ratio begins with cash from the cash flow statement.Cash interest coverage gives a more virtual(prenominal) indication of the companys ability to make the required interest payments. Earnings figures include all manner of noncash chargesdepreciation, pension contrib utions, some taxes and stock options. A company with a low income-based coverage ratio may in truth be able to meet its payment obligations, but the mask of noncash charges makes it difficult to see that. A cash-based coverage ratio gives a direct look at the cash available to pay interest. Cash current debt coverage Operating cash flowcash dividends Current debtCompanys ability to repay its current debt Cash current debt coverage ratio. The numerator consists of retained operating cash flowoperating cash flow less cash dividends. The denominator is current debtthat is, debt maturing within one year. This is, again, a direct correlate of an earnings current debt coverage ratio, but more show because it addresses managements dividend distribution form _or_ system of government and its subsequent effect on cash available to meet current debt commitments. As with the cash interest coverage ratio, the current debt ratio indicates the companys ability to carry debt comfortably.The high er the multiple, the higher the comfort level. But like most other ratios, as long as the company is not insolvent, the appropriate level varies by industry characteristics. HOW TO USE CASH RATIOS AS A MEASURE OF FINANCIAL HEALTH Beyond questions of immediate corporate solvency, auditors need to measure a clients ability to meet ongoing financial and operational commitments and its ability to finance growth. How readily can the company repay or refinance its long-term debt? Will it be able to maintain or increase its current dividend to stockholders? How readily will it be able to raise new capital?Banks, credit-rating agencies and investment analysts understandably are very concerned with these questions. Accordingly, they have genuine several(prenominal) ratios to provide answers to them. Auditors, who are more concerned about full disclosure, can use these same ratios to breeze through areas for closer scrutiny when planning an audit. Capital expenditure Cash flow from operatio ns Capital expenditures Companys ability to cover debt after maintenance or investment on plant and equipment Capital expenditure ratio. The numerator is cash flow from operations. The denominator is capital expenditures.A financially strong company should be able to finance growth. This ratio measures the capital available for internal reinvestment and for payments on existing debt. When the capital expenditure ratio exceeds 1. 0, the company has enough funds available to meet its capital investment, with some to spare to meet debt requirements. The higher the value, the more spare cash the company has to service and repay debt. As with all ratios, appropriate values vary by industry. orbitual industries, such as housing and autos, may show more variation in this figure than noncyclical industries, such as pharmaceuticals and beverages.Also, a low figure is more understandable in a growth industry, such as technology, than in a mature industry, such as textiles. Total debt Cash f low from operations Total debt Companys ability to cover future day debt obligations Total debt (cash flow to total debt) ratio. The numerator is cash flow from operations. The denominator is total debtboth long term and short term. Total cash flow to debt is of direct concern to credit-rating agencies and loan decision officers. This ratio indicates the length of time it will take to repay the debt, as agreeing all cash flow from operations is devoted to debt repayment.The freeze off the ratio, the less financial flexibility the company has and the more likely that problems can arise in the future. Auditors should take diminished financial flexibility into account when identifying wild audit areas during planning. NET FREE CASH FLOW RATIOS Other ratios that spotlight a companys viability as a going concern rely on a figuring of net free cash flow. assoil free cash flow (NFCF) is not soon enough well defined, although bankers are working to standardize these deliberations in a way that would facilitate comparisons crossways companies and across industries.However, at present, there are still many variations of net free cash flow. We propose a total free cash (TFC) ratio developed by First Interstate Bank of Nevada, which uses it to make loan decisions and loan covenant agreements. This TFC computation offers the advantage of incorporating the effects of off-balance-sheet financingby taking into account operating lease and letting payments. Total free cash (TFC) (Net income + Accrued and capitalized interest expense + derogation and amortization + Operating lease and renting expense Declared dividends Capital expenditures) (Accrued and capitalized interest expense Operating lease and rental expense + Current portion of long-term debt + Current portion of capitalized lease obligations) Companys ability to meet future cash commitments These ratios require computation of the companys net free cash flows. As net free cash flow can vary by company as well as by industry, the formulas should be considered as recommended rather than absolute. TFC ratio . The numerator of this ratio is the sum of net income, accrued and capitalized interest expense, depreciation and amortization and operating lease and rental expense less declared dividends and capital expenditures.The denominator is the sum of accrued and capitalized interest expense, operating lease and rental expense, the current portion of long-term debt and the current portion of long-term lease obligations. Varying definitions of capital expenditures can confuse the issue. Since different definitions change the value of free cash flow ratios, it is best to be clear about which definition the auditor is using and why it makes sense for a ill-tempered purpose. For example, if the auditor is nerve-wracking to determine whether the company can maintain its present level of operations, the capital spending figure used hould exclude new investments and be limited to the bill of spending required to maintain operating assets. sometimes maintenance spending is estimated at 2% of total assets, or up to 5% of property, plant and equipment. Industries with very long-lived capital assets may use smaller percentages to estimate maintenance spending. However, if the auditor is more provoke in long-term growth potential, then actual capital expenditures from the cash flow statement should be used. Cash flow adequacy (CFA) (EBITDA taxes paid interest paid capital expenditures) (Average annual debt maturities scheduled ver next 5 years) Companys credit quality These ratios require computation of the companys net free cash flows. As net free cash flow can vary by company as well as by industry, the formulas should be considered as recommended rather than absolute. Cash flow adequacy (CFA) ratio. The numerator is earnings before interest, taxes, depreciation and amortization (EBITDA) less taxes paid (cash taxes) less interest paid (cash interest) less capital exp enditures (as qualified above). The denominator is the norm of the annual debt maturities scheduled over the next five years.Cash flow adequacy helps smooth out some of the cyclical factors that pose problems with the capital expenditure ratio. It also makes allowances for the effects of a balloon payment. Companies with strong NFCF compared with forthcoming debt obligations are better credit risks than companies that must use outside capital sources. Thus, a high CFA intend high credit quality. KNOW YOUR CLIENT In order to fully understand where to set the levels at which the cash flow ratios discussed here should trigger deeper investigation, auditors need to understand their clients businesses and the industries in which they operate.As with any other ratio, an auditor should listen to the clients explanation of any unfavorable changes in cash ratios before becoming too alarmed. An auditor should know what cash concerns are critical to a companys business. We wouldnt suggest t hat a successful audit is just a matter of picking the right equations and plugging in the numbers. There are no absolutes. But powerful applied, cash flow ratios can be revealing to auditors during the audit planning stages and can give the auditor a more accurate picture of the company. Auditors must ascertain whether the financial statements are fairly presented in accordance with GAAP.They must be satisfied with the the true of the transactions and balances summarized in the four financial statements and the related disclosures. Effective auditors can use cash flow ratios to improve their understanding of the cash concerns critical to the particular company and to plan the audit more effectively. References www. emailprotected unr. edu (www. readability. com) www. emailprotected edu (www. readability. com) Exhibit 1 (www. journalofaccountancy. com) exhibit 2 (www. journalofaccountancy. com) case study (www. journalofaccountancy. com)