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HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS Creditors and lenders began using cash flow ratios because those ratios give more information about a company’s 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 particular company, her greatest concern is whether the company can pay the loan back, with interest, on time. Traditional working ca

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HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS
Creditors and lenders began using cash flow ratios because those ratios give moreinformation about a company’s ability to meet its payment commitments than dotraditional 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 particular company, her greatest concern is whether the company can pay the loan back, withinterest, on time. Traditional working capital ratios indicate how much cash thecompany had available on a single date in the past. Cash flow ratios, on the other hand, test how much cash was generated over a period of time and compare that tonear-term obligations, giving a dynamic picture of what resources the company canmuster to meet its commitments.
Operating cash flow (OCF) ratio.
The numerator of the OCF ratio consists of netcash provided by operating activities. This is thenet figure provided by the cash flow statementafter taking into consideration adjustments for noncash items and changes in working capital.The denominator is all current liabilities, takenfrom the balance sheet. Operating cash flowratios vary radically, depending on the industry.For example, the gaming industry generatessubstantial operating cash flows due to the natureof its operations, while more capital-intensiveindustries, such as communications, generate substantially less. The gaming giant,Circus Circus, exhibited an OCF of 1.737 for fiscal year l997 while the media king,Gannett, produced an OCF of 1.148 for a similar period. In order to judge whether acompany’s OCF is out of line, an auditor should look at comparable ratios for thecompany’s industry peers. (For further details, see thecase study.)
Funds flow coverage (FFC) ratio.
Thenumerator of the FFC ratio consists of earnings before interest and taxes plusdepreciation and amortization(EBITDA), which differs from operatingcash flow. Operating cash flow includescash paid out for interest and taxes,which EBITDA does not. The FFC ratiohighlights whether the company cangenerate enough cash to meet these commitments (interest and taxes). Accordingly,
Operating cash flow (OCF)
Cash flow from operationsCurrent liabilities
Company’s ability to generateresources to meet currentliabilities
Funds flow coverage (FFC)
EBITDA(Interest + Tax-adjusted* debt repayment+ Tax-adjusted* preferred-dividends)
Coverage of unavoidable expenditures
*To adjust for taxes, divide by the complement of the tax rate.
interest and taxes are excluded from the numerator. The denominator consists of interest plus tax-adjusted debt repayment plus tax-adjusted preferred dividends. Toadjust for taxes, divide by the complement of the tax rate. All of the figures in thedenominator are unavoidable commitments.An auditor can use the FFC ratio as a tool to evaluate the risk that a company willdefault on its most immediate financial commitments: interest payments, short-termdebt and preferred dividends (if any). If the FFC ratio is at least 1.0, the company canmeet its commitments—but just barely. To survive in the long run, any company musthave enough cash flow to maintain plant and equipment. To be really healthy, itshould be able to reinvest cash for growth. Accordingly, if a company’s FFC is lessthan 1.0, the company must raise additional funds to meet current operatingcommitments. To avoid bankruptcy, it must keep raising fresh capital.
Cash interest coverage ratio.
The numerator of cash interest coverage consists of cash flow fromoperations, plus interest paid plus taxes paid. Thedenominator includes all interest paid—shortterm and long term. The resultant multipleindicates the company’s ability to make theinterest payments on its entire debt load. Ahighly leveraged company will have a lowmultiple, and a company with a strong balance sheet will have a high multiple. Anycompany with a cash interest multiple less than 1.0 runs an immediate risk of potentialdefault. The company must raise cash externally to make its current interest payments.The cash interest coverage ratio is analogous to the old-fashioned coverage ratio (alsoknown as the interest coverage ratio). However, where the numerator of the coverageratio begins with earnings from the income statement, the numerator of the cashinterest coverage ratio begins with cash from the cash flow statement. Cash interestcoverage gives a more realistic indication of the company’s ability to make therequired interest payments. Earnings figures include all manner of noncash charges— depreciation, pension contributions, some taxes and stock options. A company with alow income-based coverage ratio may actually be able to meet its paymentobligations, 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 ratio.
Thenumerator consists of retained operatingcash flow—operating cash flow less cashdividends. The denominator is current debt —that is, debt maturing within one year.
Cash interest coverage
Cash flow from operations+ Interestpaid + Taxes paidInterest paid
Company’s ability to meet interestpayments
Cash current debt coverage
Operating cash flow—cash dividendsCurrent debt
Company’s ability to repay its current debt
This is, again, a direct correlate of an earnings current debt coverage ratio, but morerevealing because it addresses management’s dividend distribution policy and itssubsequent effect on cash available to meet current debt commitments. As with the cash interest coverage ratio, the current debt ratio indicates the company’sability to carry debt comfortably. The higher the multiple, the higher the comfortlevel. But like most other ratios, as long as the company is not insolvent, theappropriate 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 aclient’s ability to meet ongoing financial and operational commitments and its abilityto finance growth. How readily can the company repay or refinance its long-termdebt? Will it be able to maintain or increase its current dividend to stockholders? Howreadily will it be able to raise new capital?Banks, credit-rating agencies and investment analysts understandably are veryconcerned with these questions. Accordingly, they have developed several ratios to provide answers to them. Auditors, who are more concerned about full disclosure, canuse these same ratios to pinpoint areas for closer scrutiny when planning an audit.
Capital expenditure ratio.
The numerator is cash flow from operations. Thedenominator is capital expenditures. A financially strong company should be able tofinance growth. This ratio measures thecapital available for internalreinvestment and for payments onexisting debt. When the capitalexpenditure ratio exceeds 1.0, thecompany has enough funds available tomeet its capital investment, with someto spare to meet debt requirements. The higher the value, the more spare cash thecompany has to service and repay debt. As with all ratios, appropriate values vary byindustry. Cyclical industries, such as housing and autos, may show more variation inthis figure than noncyclical industries, such as pharmaceuticals and beverages. Also, alow figure is more understandable in a growth industry, such as technology, than in amature industry, such as textiles.
Total debt (cash flow to total debt) ratio.
Thenumerator is cash flow from operations. Thedenominator is total debt—both long term and
Capital expenditure
Cash flow from operationsCapital expenditures
Company’s ability to cover debtafter maintenance or investmenton plant and equipment
Total debt
Cash flow from operationsTotal debt
Company’s ability to cover futuredebt obligations
short term. Total cash flow to debt is of direct concern to credit-rating agencies andloan decision officers. This ratio indicates the length of time it will take to repay the debt, assuming all cashflow from operations is devoted to debt repayment. The lower the ratio, the lessfinancial flexibility the company has and the more likely that problems can arise in thefuture. Auditors should take diminished financial flexibility into account whenidentifying high-risk audit areas during planning.
NET FREE CASH FLOW RATIOS
Other ratios that spotlight a company’s viability as a going concern rely on acomputation of net free cash flow. Net free cash flow (NFCF) is not yet well defined,although bankers are working to standardize these computations in a way that wouldfacilitate comparisons across 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 loandecisions and loancovenant agreements.This TFC computationoffers the advantageof incorporating theeffects of off-balance-sheet financing—bytaking into accountoperating lease andrental payments.
TFC ratio
. Thenumerator of this ratiois the sum of netincome, accrued and capitalized interest expense, depreciation and amortization andoperating lease and rental expense less declared dividends and capital expenditures.The denominator is the sum of accrued and capitalized interest expense, operatinglease and rental expense, the current portion of long-term debt and the current portionof long-term lease obligations.Varying definitions of
capital expenditures
can confuse the issue. Since differentdefinitions change the value of free cash flow ratios, it is best to be clear about whichdefinition the auditor is using and why it makes sense for a particular purpose.
Total free cash (TFC)†
(Net income + Accrued and capitalized interestexpense + Depreciation and amortization+ Operating lease and rental 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)
Company’s ability to meet future cash commitments
† These ratios require computation of the company’s net free cash flows. As netfree cash flow can vary by company as well as by industry, the formulas should be considered as recommended rather than absolute.

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