Important Ratios for Cash Flow Analysis (2024)

An old saying in business is that cash is king. And for a small business, cash drives its net income because it provides the business the means to remain solvent to operate.

Business solvency occurs when a company has enough investment in assets to cover its debt or liabilities. Solvency ratios measure the extent to which a business can cover its liabilities in the long term or during more than one year. Cash flow ratios are more accurate at measuring a firm's liquidity and solvency than are ratios derived from the income statement or balance sheet.

Knowing how to develop and apply the information obtained from cash flow ratios is crucial for a viable business. Business viability is the ability of a business to generate profit, or net income, on an ongoing basis, year after year.

What a Cash Flow Statement Tells You

The statement of cash flows is one of the three financial statements a business owner uses in cash flow analysis. Cash flow is the money that flows into and out of a business and is the driving force behind its operations.

A statement of cash flows breaks down the firm's cash flows into three types: operating cash flows, financing cash flows, and investing cash flows. Operating cash flows are the increases and decreases in the current asset and current liability accounts over a time period. Financing cash flows, meanwhile, are the result of funding to the business or the return of funding. And finally, investing cash flows result from investing activities by the firm into financial securities, property, plant, or equipment.

5 Ratios for Cash Flow Analysis

Analyzing these three types of cash flows, combined with balance sheet and income statement data, gives the firm a wealth of information it can use for financial analysis of its cash position.

Current Liability Coverage Ratio

This ratio indicates the ability the business's operations have to generate cash that can be used to cover debts that need to be paid within a year's time. In other words, the current liability coverage ratio measures the business's liquidity.

Also called the cash current debt coverage ratio, this ratio looks at how the business's dividend policy affects the amount of cash available to meet current debt obligations. The ratio is calculated as follows:

Net cash flow from operating activities comes from the statement of cash flows, and average current liabilities comes from the balance sheet.

Operating Cash Flow Ratio

The operating cash flow ratio is different from the current liability coverage ratio in only one way: It does not include dividends in the formula. However, this ratio is used to determine the amount of cash generated by the firm's basic business operations. It is analyzed by both management and investors in order to determine the overall health of the firm.

This ratio is also a liquidity ratio and will help determine if the business can meet its short-term debt liabilities without considering its dividend policy. Like the previous ratio, if the ratio is less than 1, the firm is facing a cash crisis.

Net cash flow from operations is taken off the statement of cash flows, and current liabilities (which may or may not be an average) is taken off the balance sheet.

Cash Interest Coverage Ratio

The cash interest coverage ratio measures the ability of a business to meet its interest payments on its debt financing. It is a similar measure to the interest coverage ratio, but since it uses cash and not earnings in the denominator, it is a more realistic measure. If the ratio is less than one, the business does not have enough cash to meet its interest obligations on its short and long-term debt.

Interest and taxes come from the income statement.

Cash Flow Coverage Ratio

The previous three cash flow ratios have been liquidity ratios. The cash flow coverage ratio is considered a solvency ratio, so it is a long-term ratio. This ratio calculates whether a company can pay its obligations on its total debt including the debt with a maturity of more than one year. If the answer to the ratio is greater than 1.0, then the company is not in danger of default.

Total liabilities come from the balance sheet.

Price-to-Cash-Flow Ratio

The price-to-cash flow ratio is a valuation ratio useful when a business is publicly traded. It measures the amount of operating cash flow generated per share of stock. This ratio is generally accepted as being more reliable than the price/earnings ratio, as it is harder for false internal adjustments to be made.

To calculate the priceto cash flow ratio, use this formula:

The share price is usually the closing price of the stock on a particular day, and operating cash flow per share is calculated by dividing the total net operating cash flow by the number of shares outstanding.

The Bottom Line

Large and small businesses alike need to be aware of the firm's cash position at all times. The cash flow ratios are often the best measures of the liquidity, solvency, and long-term viability of a business firm.

Cash flow ratios are sometimes reserved for advanced financial analysis. In the case of a small business, cash is very important for survival. It would serve a business owner or manager well to calculate the cash flow ratios in order to have an accurate picture of the actual cash position and viability of the business. The viability of the business is its ability to survive in the long run and the effectiveness of its operations.