Calculating Cash Flow Ratios

**The cash flow statement, which is often overlooked in favor of the balance sheet and income statement, is the optimum resource for testing a company's liquidity. Two important ratios derived from the cash flow statement are the operating cash flow ratio and the cash current debt coverage ratio.**

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One of the most frequently overlooked financial statements is the cash flow statement, which normally plays third fiddle to the income statement and the balance sheet (or, even worse, falls off the radar screen altogether).

Traditional financial statement liquidity ratios are based upon utilization of two balance sheet ratios: the current ratio (current assets / current liabilities) and the quick ratio [(cash + cash equivalents + accounts receivable) / current liabilities]. In this report I'll use the cash flow statement to measure a company's liquidity in a different way than you normally see. I think you'll find this a more reliable tool than those usually used to measure liquidity.

The problem with using just the balance sheet for liquidity analysis is that it presents data that measures only where a company stands at a particular point in time. And the income statement includes many non-cash allocations, accounting conventions, accruals, and reserves that don't reflect a company's true cash position. As a matter of fact, one of the reasons that we look at a company's Cash King Margin over in the Rule Maker Portfolio is its focus on a company's cash earnings rather than its accounting earnings.

The cash flow statement records changes in both the income statement and the balance sheet while eliminating the impact of accounting conventions. What's left is what shareholders should care about most: cash available for operations and investments.

In addition, while the balance sheet ratios I mentioned above measure how liquid a company was on a single date in the past, cash flow ratios can be used to evaluate how much cash a company generated over a period of time and compare that figure to its near-term obligations. The result is a more dynamic picture of what resources a company has available to meet its current financial commitments.

In the remainder of this column, I'll discuss two of the four ratios I'm familiar with that can be used to test a company's solvency. The other two, as well as some additional ratios that can be used to test a company's financial health, will be the subject of a future article.

When computing any of the ratios discussed below, it is important to remember that the ratios are most meaningful when they are used to compare peer companies. In the discussion of each ratio, I'll include six companies that are generally classified as Internet companies to help make the comparisons more valuable.

The operating cash flow ratio (OCF) measures a company's ability to generate the resources required to meet its current liabilities. The equation is:

Cash flow from operations / Current liabilities

The numerator of this fraction, which is found right on the cash flow statement, represents a company's accounting earnings adjusted for non-cash items and changes in working capital. The denominator takes into account all current liabilities found on the balance sheet.

The purpose of this ratio is to assess whether or not a company's operations are generating enough cash flow to cover its current liabilities. If the ratio falls below 1.00, then the company is not generating enough cash to meet its current commitments. In this case, the company is likely to have to find other sources to fund its operations or slow the rate at which it is spending its cash. Any existing cash balance can help the company meet these needs, but there has to be some concern about whether or not the company will be able to continue operating without raising additional funds, as the existing cash balance cannot last forever.

Let's use the balance sheet and cash flow statement data for the last full fiscal year of **Amazon.com** (Nasdaq: AMZN), **CDNow** (Nasdaq: CDNW), **CMGI** (Nasdaq: CMGI), **eBay** (Nasdaq: EBAY), **Lycos **(Nasdaq: LCOS) and **Yahoo! **(Nasdaq: YHOO) to calculate the OCF of each:

Cash Flow Curr. Liab. OCF AMZN (90,875) 738,935 (0.12) CDNW (51,770) 67,415 (0.77) CMGI 90,364) 676,329 (0.13) EBAY 66,564 88,825 0.75 LCOS (37,947) 90,426 (0.42) YHOO 216,336 192,319 1.12

$ in thousands

Based on these numbers,Yahoo! is the only company that has operations generating enough cash to meet its current obligations. Note also that approximately one-half of Yahoo!'s current liabilities are in the form of deferred revenues. Deferred revenues are what I refer to as a good liability, as they represent revenue collected by the company before at least a portion of the related services have been performed (i.e., the company has to perform a service rather than expend cash to pay off its creditor). If we eliminate deferred revenue from this equation, then Yahoo!'s OCF is a much healthier 2.13. In addition, it is possible that each of these companies is able to fund a portion of its operations by collecting revenue for anything it sells before having to pay the supplier for the related products. Amazon is an example of a company that is able to take advantage of this "float."

In some ways, it's even more important to assess whether or not a company is generating enough cash to repay its current debts. If the company defaults on these obligations, then the risk of bankruptcy increases, as does the company's risk of having its assets seized by creditors. If a company cannot meet its current debt obligations, then it's not going to be easy for it to borrow additional funds. Even in the event that it can borrow funds, the associated terms are not likely to be very favorable.

Cash current debt coverage (CCD) is a ratio that can be used to measure a company's ability to repay its current debt. CCD is calculated as follows:

(Cash flow from operations � cash dividends) / Current interest-bearing debt

The numerator of this fraction represents a company's retained operating cash flow. While none of the companies that we're looking at pay dividends, you should know for future reference that cash dividends paid can be found in the "net cash used for financing" section of the cash flow statement. If you're not sure which current liabilities are interest-bearing, you may want to refer to this column. Like with the OCF, if a company's CCD is less than 1.00, the company is not generating enough cash to repay its current debt obligations. The higher the multiple calculated by this ratio, the higher the comfort level you should feel when you see debt on a company's balance sheet. Of course, as long as the company is not insolvent, the appropriate level varies by the characteristics of the industry.

Let's calculate the CCD for our six companies:

Cash Flow Div. Curr. Debt CCD AMZN (90,875) 0 39,210 (2.32) CDNW (51,770) 0 1,671 (30.98) CMGI (90,364) 0 25,258 (3.58) EBAY 66,564 0 12,285 5.42 LCOS (37,947) 0 2,589 (14.66) YHOO 216,336 0 0 No Debt!

$ in thousands

eBay and Yahoo!, which is debt-free, once again emerge as the most liquid companies in this group. While the other four companies did not generate enough cash from operations during their last fiscal year to repay their debts, I find the relative progression of the numbers quite interesting. While all of the companies look like they will either have to utilize some of their cash balance or raise additional funds in order to repay debt, on a comparative basis, the liquidity of CDNow looks significantly worse than that of its competitors. After looking at the ratios I've calculated, I certainly have some concerns about CDNow's chances of future survival without the infusion of cash that does not carry an interest cost.

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