20.6 Analysis
Ratio Analysis – Overview
Ratio analysis occurs when relationships between selected financial data (presented in the numerator and denominator of the formula) provide key information about a company. Ratios from current year financial statements alone may not be as useful as when they are compared with benchmark ratios. Examples of benchmark ratios are a company’s own historical ratio trends, future ratio targets set by management as part of its strategic plan, industry sector ratios from the sector that the company operates in, or ratios from competitors, if obtainable.
Care must be taken when interpreting ratios because companies within an industry sector may use different accounting policies, which affect the comparison of ratios. In the end, ratios are based on a company’s current and past performance and are merely indicators. Further investigation is needed to gather more business intelligence about the reasons why certain variances in the ratios occur.
Statement of Cash Flows Analysis
Not all companies who report profits are financially stable. This is because profits do not necessarily translate to cash. Looking at the statement of cash flows for Watson Ltd. above, we see that it reported a $77,000 net income (profit), but it is currently experiencing significant negative cash flows from its operating activities.
As previously discussed, one of the most important aspects of the statement of cash flows is the cash flows generated from the operating activities, as this reflects the business’s day-to-day operations. If sufficient cash is generated from operating activities, then the company will not have to increase its debt, issue shares, or sell off useful assets to pay its bills. However, as we saw the opposite was true for Watson Ltd. as it increased its short-term debt (accounts payable), sold off a building, and issued 25% more common shares.
Another critical aspect is the sustainability of positive cash flows from operating activities. Perhaps Watson Ltd.’s negative cash flow from operating activities will turn itself around in the next reporting period, as this would be the company’s best hope. Other companies who experience positive cash flows from operations must also ensure that it is sustainable and can be repeated consistently in the future.
In summary, it is critical to monitor the trends regarding cash flows over time. Without benchmarks, such as historical trends or industry standards, ratio analysis is not as useful. If trends are tracked, ratio analysis can be a powerful tool to evaluate a company’s cash flows.
Statement of Cash Flows Ratios
Below are some of the cash flows ratios currently used in business.
| Ratio | Formula | Purpose |
|---|---|---|
| Liquidity ratios – ability to pay short term obligations | ||
|
Current cash debt coverage ratio |
 |
ability to pay short term debt from its day-to day operations. A ratio of 1:1 is reasonable. |
| Financial flexibility – ability to react to unexpected expenses and investment opportunities | ||
|
Cash debt coverage ratio |
 |
the ability to pay debt from net cash from operating activities |
For Watson Ltd., since the net cash flow from operating activities is a loss of $101,660, the two ratios above would be unfavourable. For example, the current cash debt coverage ratio would be a negative 26.4% (
) and the cash debt coverage ratio would be a negative 16.1% (
). Without the historical trends for these ratios, it is impossible to say if Watson Ltd. can turn things around or not.
Free Cash Flow (FCF) Analysis
Another way to assess a company’s cash flow liquidity is the free cash flow. Free cash flow is the cash flow remaining from operating activities after deducting cash spent on capital expenditures, such as purchasing property, plant and equipment. Some companies also deduct cash paid dividends. The remaining cash flow represents cash available to the company to do other things such as expand its operations, pay off long-term debt or reduce the number of outstanding shares. Below is the calculation using the data from Watson Ltd.’s statement of cash flows.
| Watson Ltd. Free Cash Flow December 31, 2020 |
|
|---|---|
| Cash flow provided by operating activities | $(101,660) |
| Less capital expenditures | 0 |
| Dividends | (42,590) |
| Free cash flow | $(144,250) |
It is no surprise that Watson Ltd. has no free cash flow and no financial flexibility, since its operating activities are in a negative position. Watson Ltd. met its current year dividend cash requirements by selling more common shares to raise additional cash, thus diluting the shareholders’ investment position. When calculating the free cash flow, the capital expenditures amount should be limited to those that relate to daily operations that are intended to sustain ongoing operations, such as PPE expenditures. Meaning, capital expenditures purchased as investments are usually excluded from the free cash flow analysis.
