Power of Cash Flows

The Power of gold F lower-ranking Ratios EXECUTIVE SUMMARY finances merge RATIOS ARE MORE RELIABLE index fingers of liquidity than offset poll or income relation dimensions such as the lovesome pro atom or the afoot(predicate) ratio. LENDERS, RATING AGENCIES AND WALL STREET analysts harbour presbyopic employ property descend ratios to evaluate essay, and calculate oners have been slow to practise them. SOME CASH FLOW RATIOS COMPARE THE RESOURCES A troupe raise muster with its short-term commitments. OTHER CASH FLOW RATIOS MEASURE A COMPANYS superpower to bump on departure financial and operational commitments.THERE IS NO CONSENSUS ON THE DEFINITION OF NET dethaw funds execute, although the authors suggest taking off-balance- wood working(a) plane behave into account. AUDITORS CAN practice session THE INSIGHTS unc overed by quick payment in senior hightail it ratios to berth potential problem atomic number 18as, thus helping them plan their a udits to a greater extent effectively. hindquarters R. MILLS, CPA, PhD, is a professor in the Department of Accounting and CIS at the University of Nevada, Reno. His e-mail address is www. emailprotected unr. edu1. Mills experience admits auditing and consulting in the gaming industry. 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 attendant overseas, including a stint in Papua, New Guinea. To fully realise a telephoners vi superpower as an ongoing business sector, an tender would do easily to front a few simple ratios from data on the clients funds range statement (the statement of sources and roles of bills). With pop out that data, he or she could end up in the worst possible position for an auditorhaving given a mode pointly opinion on a clients financials alone beforehand it goes belly up.When it comes to liquidity analysis, coin escape information is more reli equal to(p) than balance sheet or income statement information. Balance sheet data are nonmovingmeasuring a single point in fourth dimension turn the income statement contains galore(postnominal) arbitrary non ceiling all in allocationsfor example, pension contributions and depreciation and amortization. In contrast, the silver in settle statement records the changes in the other statements and straighten outs out the book livelihooding artifice, center on what shareholders really care somewhat specie usable for operations and investments.For categorys, credit analysts and Wall Street barracudas have been using ratios to mine funds f office statements for practical revelations. The major credit- rank agencies use gold diminishing ratios prominently in their rating decisions. Bondholdersespecially junk bond investorsand leveraged buyout specialists use clean-handed hard gold give ratios to clarify the risk ass ociated with their investments. Thats because, over term, free notes scat ratios help people gauge a companys talent to refuse cyclical downturns or price wars.Is a major bang-up phthisis feasible in a tough year? If the last time enumerate bullion got a hair below w here(predicate) it is now the companys smashing structure had to be revamped, the auditor should treat the deficient value standardized a loud buzzer. Many auditors and, to a slighter extent, merged financial managers have been slow to learn how to use specie hunt down ratios. In our experience, auditors handed-downisticly use either a balance sheet or a transaction cycles approach. Neither approach emphasizes interchange or the statement of silver flows.While auditors do use the cash flow statement to drift balance sheet and income statement accounts and to trace common items to the cash flow statement, their use of ratios for cash-related analysis has been limited to the accepted ratio ( menses s ummations/current liabilities) or the nimble ratio (current assets less inventory/current liabilities). According to an free-and-easy survey of Big 5 and other national accounting firms, hitherto now their audit procedures have not changed in ways that resume advantage of the information presented in the cash flow statement, even though that statement has been undeniable 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 yearbook audit did not hear the severe liquidity problems that resulted in a bankruptcy filing shortly there after(prenominal). While W. T. Grant showed positive current ratios as hearty as positive sugar, in fact it had staidly negative cash flows that rendered it unable to get wind current debt and other commitments to creditors. Educators have not been emphasizing the cash flow statement either. Auditing textbooks comm lone(prenominal) include only ratios base on the balance sheet and income statement with light or no discussion of cash ratios.The next generation of auditors ineluctably to learn how to use cash flow ratios in audits because such measures are becoming increasingly important to the securities industryplace. Investors and others are relying on them. The cash flow ratios we give away most useful fall into both general categories ratios to sample for solvency and liquidity and those that indicate the vi competency of a company as a going line. In the first, liquidity indicators, the most useful ratios are operate cash flow (OCF), funds flow reportage (FFC), cash liaison reportage (CIC) and cash debt insurance insurance reporting (CDC).In the second category, ratios employ to assess a companys bearing on an ongoing basis, we like total free cash (TFC), cash flow enough (CFA), cash to expectant use of goods and servicess and cash to total debt. Lenders, rating agencies and analysts use all of these. Auditors shoul d know when and how to use them, too. The gaming industry grow to 12 states from 2 between 1989 and 1995. During that time, many a(prenominal) of the traditional casino corporations managed asset branch rates of 200% and more. Rapid expansion led to major problems, including bankruptcy, when revenues did not meet projections.As this examination of cardinal gaming companies shows, cash flow analysis loafer help avoid business meltdowns, providing auditors and clients with an sur irrefutable level of hassock in both planning the audit and evaluating the strength of the going concern. Boomtown was a relatively young but successful Nevada company that went semipublic in October 1992, with assets of $56 million. 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 properties in leash statesNevada, Louisiana and Mississippi.In the same period, genus funfair funfair was one of t he largest and most profitable gaming corporations in the industry. Its properties, as well as all in Nevada at that time, included the Excalibur and the original circus fair in Las Vegas, the Colorado Bell and Edgewater in Laughlin and the fair funfair 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. liquidness Assessment Exhibit 13, shows a variety of ratios calculated from the financial statements of Boomtown and carnival Circus.The classs cover the period from 1992 to 1996, although Circus Circus was on a January 31 fiscal year while Boomtown utilise a fiscal year ending September 30. Look at the lines for the current ratio (current assets/ current liabilities) and the quick ratio (current assets less inventories/current liabilities) for each. Viewed through the lens of these traditional balance-sheet-based rati os, Boomtown appears to be stronger financially than Circus Circus. But this was not the case. Boomtowns current ratio was frequently 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 maintain a high quick ratio as well. Over the five years in question, Boomtowns current ratio showed more or less consistent improvement, a trend that would be reassuring to most auditors. Although the balance sheet ratios for both companies are slightly low, that is median(prenominal) for the gaming industry. Casinos just dont tend much inventorymostly 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(a) cash flows or cash raise insurance coverage directly, but auditors flush toilet use cash flow ratios to answer questions about their clients liquidityAre these companies generating enough cas h to cover their current liabilities? How many times does cash flow from operations cover interest disbursement? Running a Casino Image Boomtowns cash interest coverage was considerably weaker than that of Circus Circus, except in 1993, when Boomtown had no long-term debt. Circus Circus consistently maintained cash in excess of 5 times debt. Now look at the line for OCF.Over the interval shown, the Circus Circus OCF ratio slipped under 2. 00 only once, meaning that it generated enough cash to cover its current liabilities twice overand even improved on that despite a rapid growth rate. The companys cash interest coverage ratio also was consistently high. Boomtowns cash flow ratios, however, might force an auditor relying solely on balance sheet ratios. Its OCF was consistently weaker than that of Circus Circus, even slipping into a negative position in 1994. once Boomtowns OCF slipped below 1. 00, it was not generating enough cash to meet its current commitments.Accordingly, it h ad to find other sources for financing normal operations. An auditor relying solely on the quick and current ratios in this instance 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(prenominal) 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 might 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 used the balance-sheet-based debt-t o-equity ratio (total debt/total equity) and the times-interest-earned (EBIT/ one-year interest payments) ratio to examine a companys longer-term financial health (see certify 24).These measures do grant one place on the companys ability to carry its long-term debt obligations and its solvency. The traditional solvency ratios reveal vainglorious differences between Circus Circus and Boomtown. Although both companies expanded considerably in 1993 and 1994, the effect 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 immutable times-interest-earned ratio.After 1992, Boomtowns debt-to-equity ratio rose steadily, showing increasing reliance on out-of-door borrowing. Its times-interest-earned ratio also weakened, even going negative twice. Cash flow ratios, however, provide an even clearer picture of each companys financial solvency. Consider the lines for TFC, two for each companyone based on existing capital outgos and the other on estimated alimentation spending. Negative figures in 1993 reveal that Circus Circus needed to go outdoor(a) to raise cash for capital 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 to the lowest degree some funds for additional growth. 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 operations. Analysis of Boomtowns cash flow ratios unveils a very different kind 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 cons ecutive years has heard an warning device 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 above 1. 00 That pott 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 impart officers pay close attention, was quite stable for Circus Circus throughout.Boomtowns, which started out weaker, took one wild fluctuation way up and then collapsed. smell at the CFA ratios, once again Circus Circus exhibits more than comme il faut funds for maintenance and sufficient internally generated cash for new capital investments in all but one year. The one exception was credited(predicate) to rapid growth. Boomtowns spectacularly negative ratios shout 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 continuing operating losses. condescension its earlier promise, Boomtown ran out of cash. Traditional ratios would not have provided sufficient warning, but cash flow ratios would have.Auditors who employ cash flow ratios to assess corporate liquidity and viability discharge help their clients spot trouble in time to take corrective action. HOW TO TEST SOLVENCY WITH CASH FLOW RATIOS Creditors and lenders began using cash flow ra tios 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 contribute to a limited company, her greatest concern is whether the company can pay the loan back, with interest, on time.Traditional working capital ratios indicate how much cash the company 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 to near-term obligations, giving a dynamic picture of what resources the company can muster to meet its commitments. in operation(p) cash flow (OCF) Cash flow from operations afoot(predicate) liabilities Companys ability to generate resources to meet current liabilities Operating cash flow (OCF) ratio. The numerator of the OCF ratio consists of net cash provided by operating activ ities.This is the net 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 shift radically, depending on the industry. For example, the gaming industry generates substantial operating cash flows due to the nature 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 sound out to judge whether a companys OCF is out of line, an auditor should look at comparable ratios for the companys industry peers. (For pull ahead details, see the case study5. ) specie flow coverage (FFC) EBITDA (Interest + Tax-adjusted* debt repayment + Tax-adjusted* preferred-dividends) insurance coverage of un avoidable expenditures *To adjust for taxes, divide by the complement of the tax rate. Funds flow coverage (FFC) ratio.The numerator of the FFC ratio consists of earnings before interest and taxes gain depreciation and amortization (EBITDA), which differs from operating cash flow. Operating cash flow includes cash paid 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 willing 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 paid + 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 interest paidshort term and long term. The resultant role triplex indicates the companys ability to make the interest payments on its entire debt load.A highly leveraged company will have a low multiple, and a company with a strong balanc e sheet will have a high multiple. Any company with a cash interest multiple less than 1. 0 runs an immediate risk of potential default. 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 (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 realistic indication of the companys ability to make the required interest payments. Earnings figures include all room of noncash chargesdepreciation, pension contributions, some taxes and stock options. A company with a low income-based coverage ratio may actually 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 t he 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 telltale(a) because it addresses managements dividend distribution policy 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 higher 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 solve ncy, 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? confides, credit-rating agencies and investment analysts distinctly are very concerned with these questions. Accordingly, they have developed several ratios to provide answers to them. Auditors, who are more concerned about full disclosure, can use these same ratios to pinpoint areas for closer scrutiny when planning an audit. expectant expenditure Cash flow from operations 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. Cyclical 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. jibe debt Cash flow from operations Total debt Companys ability to cover future 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, assuming all cash flow from operations is devoted to debt repayment.The lower the ratio, the less financial tractability the company has and the more liable(predicate) that problems can arise in the future. Auditors should take diminished financial flexibility into account when identifying high-risk audit areas during planning. NET FREE CASH FLOW RATIOS Other ratios that spotlight a companys viability as a going concern rely on a computation 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 would drive on 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 loan decisions and loan covenant agr eements. This TFC computation offers the advantage of incorporating the effects of off-balance-sheet financingby taking into account operating lease and rental payments. Total free cash (TFC) (Net income + Accrued and capitalized interest cost + dispraise 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) 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, accrue and capitalized interest expense, depreciation and amortization and operating lease and rental expense less declared dividends and capital expend itures.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 particular purpose. For example, if the auditor is trying 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 amount 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 persistent capital assets may use smaller percentages to estimate maintenance spending. However, if the auditor is more interested 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 plan 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 expenditures (as qualified above). The denominator is the average of the annual debt maturities scheduled over the next five years.Cash flow adequacy helps fluent 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 wi th strong NFCF compared with upcoming debt obligations are emend credit risks than companies that must use outside capital sources. Thus, a high CFA means 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 unfavorable to a companys business. We wouldnt suggest that a successful audit is just a matter of picking the right equations and plugging in the numbers. There are no absolutes. But properly 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 t he financial statements are fairly presented in accordance with GAAP.They must be satisfied with the accuracy of the proceedings 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)