Chapter 16: Statement of Cash flows

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Contents

Learning Objectives[edit]

  • Learn about the purpose of the statement of cash flows
  • Learn about the various sections of the statement of cash flows
  • Learn how to prepare a statement of cash flows using the indirect method
  • Learn how to prepare a statement of cash flows using the direct method
  • Learn how to prepare the investing section of the statement of cash flows
  • Learn how to prepare the financing section of the statement of cash flows
  • Learn about required disclosures of noncash activities

16.1 - Purpose of the Statement of Cash Flows[edit]

The statement of cash flows is designed to summarize an entity’s cash inflows and outflows during a period of time. Cash inflows are reported as positive amounts and cash outflows are reported as negative amounts. The cash flows are changed by operating, investing and financing activities. A central focus of the statement of cash flows is to provide users with information about an entity’s liquidity. Liquidity is a firm’s ability to meet its obligations as they come due which most often are settled in the form of cash or cash equivalents. A firm that is able to meet its obligations as they come due is called being solvent. A secondary objective of the statement of cash flows is organizing the information in such a manner that it provides information on the type of cash flows by source. The three sources of cash flows are: operating, investing and financing activities. A financial statement user would need to be able to determine how much cash inflows/outflows are being generated by business operations. Furthermore, the user would need to be able to figure out how other non-operating cash flows (investing or financing) are being generated or used. The statement of cash flows is an integral part of a full set of financial statements.

16.2 - Cash and Cash Equivalents Defined[edit]

Cash is defined as money in coins or currency as well as funds in bank accounts that are available on demand. A cash equivalent is defined as liquid, short-term investments that have the following characteristics:

  • Convertible into a specific amount of cash within a short period of time.
  • The risk of change in value due to fluctuating interest rates is very low. This requirement generally means the asset is within 3 months of maturity and is low risk.

16.3 - Structure of The Statement of Cash Flows[edit]

The statement of cash flows is organized based on operating activities, investing activities and financing activities classifications.

  • Operating Activities – Cash flows from this source include cash inflows and outflows that occur from the company’s primary business operations. This section often includes transaction data that is included on the income statement. Current assets and current liabilities are included in this section. However, current liabilities associated with long-term notes/bonds are not included in this section. They are included in financing activities. Some examples of transactions that would be considered operating activities would be: cash receipts from customers or cash payments to suppliers for inventory purchases.
  • Investing Activities – This section involves the sale and purchase of noncurrent assets (long-term assets). Examples of noncurrent assets included in this section are property, plant and equipment (PP&E), and stock investments (securities) other than the company's own stock.
  • Financing Activities – This section involves liabilities related to investors, shareholders or creditors. It also includes transactions that involve paying shareholders, investors or repaying creditors. Examples of transactions include: borrowing funds or repaying funds through the use of bonds, sale of stock, or paying dividends. As a general rule, this section revolves around noncurrent liabilities and equity transactions (owner’s equity).

The following chart summarizes typical transactions that affect each section of the statement of cash flows:

CH 16 Operationg Section Graphic.png


CH 16 Investing Section Graphic.png


CH 16 Financing Section Graphic.png

The following is a typical statement of cash flows (prepared using the indirect method, discussed later):

CH 16 Statement of Cash Flows.png

As you can see, the statement is organized by operating, investing and financing cash flow sections. The noncash cash flow section is for transaction that do not involve an exchange of cash. For those transactions, the transaction was conducted without an effect on cash. The ending cash balance at the end of the year ($11,031,000) will equal the cash balance as reported on the December 31st, 2016 balance sheet.

Now that we have a high-level overview of the statement of cash flows, we will move on to discussing each section of the statement of cash flows in greater detail. Our discussion will focus on the overall theory behind each section followed by relevant calculations for each section.

16.4 - Operating Section[edit]

As mentioned earlier, the operating section is focused on cash inflows and outflows from primary operations which impacts current assets and current liabilities. The goal of this section is to calculate an ending balance called “net cash provided by (used by) operating activities.” To calculate this balance, we can use one of two methods: the direct method or the indirect method. Both methods will calculate the exact same ending balance for the operating cash flows. We will discuss the difference between the two methods as we calculate each method. We will be learning how to calculate operating cash flows using both methods.

16.5 - Operating Section: Indirect Method[edit]

The indirect method begins with net income as reported on the income statement. We then adjust that amount by adding or subtracting non-cash accounts that were originally used to calculate net income. If you recall from our chapter on the income statement, you will remember that non-cash accounts were either added or subtracted to calculate net income. Using the indirect method, we will remove the impact of all accounts that were non-cash. We then follow up by adding or subtracting accounts that have an impact on cash. In essence, we are going from an accrual-basis net income amount to a cash-basis calculation of cash flows by adding or subtracting specific accounts. The indirect method is used more often due to the accounting information needing to prepare it being readily available without much additional effort.

The general format of the indirect method presentation is as follows:

CH 16 Statement of CashFlows Indirect Method.png

We will now do a step-by-step example and explain each step in detail.

To calculate operating cash flows using the indirect method we will begin by analyzing changes in noncash balance sheet accounts. The reason the indirect method works is because of the interrelations between accounts in the accounting equation. If you recall from earlier chapters, you will remember that assets = liabilities + owner's equity.

If we analyze the accounting equation with cash involved, we can better understand how the indirect method works. Cash is an asset so we can separate the asset account into noncash assets and cash. We end up getting the following equations:

Cash + Noncash Assets = Liabilities + Owner's Equity

Using simple algebra, we can get the following:

Cash = Liabilities + Owner's Equity - Noncash Assets

As we quickly realize, we can determine a change in cash by determining the changes in Liabilities, owner's equity and noncash asset accounts. The following equation demonstrates this:

Change in Cash = Change in Liabilities + Change in Owner's Equity - Change in Noncash Assets

We then proceed to use the Income Statement and Balance Sheet to determine these changes.

The first step is to determine what is the net income for the period as this is the first line item reported. To determine the net income, we will be analyzing the income statement.

STEP 1: Determine Net Income[edit]

If the income statement is not already prepared then we must prepare it to calculate our net income for the period in question. Chapter 4 lists how to prepare an income statement. In this case, we will use the following income statement to determine net income:

Multi-Step Income Statement, Chapter 4.png

As you can see the company had net income of $4,750 for the previous 12-month period. Remember the net income amount used must match the amount for the period that we are preparing the statement of cash flows for. If we are preparing a quarterly (3 month) statement of cash flows then we must use net income for the exact same 3 months. In this case, we are preparing an annual statement of cash flows so we can use the net income from this income statement. The $4,750 will be the first line reported for the operating section of our statement of cash flows.

STEP 2: Convert Accrual Basis Net Income to Cash Basis[edit]

The $4,750 net income number we have is an amount that is based on accrual basis of accounting. We will have to convert this net income number into a cash basis amount by adjusting it for non-cash transactions that are factored in when using accrual basis. We do this by analyzing comparative changes in balance sheet and income statement accounts. These adjustments are reflected on the statement of cash flows operating section under the "adjustments to reconcile net income to net cash flows provided by operating activities" section.

When performing our balance sheet and income statement analysis, we must reverse the following accrual accounting effects on net income:

Impact of noncash current operating assets and current liabilities are adjusted:

  • Deduct increases in current noncash operating assets
  • Add decreases in current noncash operating assets
  • Add increases in current noncash current liabilities
  • Deduct decreases in current noncash current liabilities

Example: A company sells inventory on credit and increases an account receivable by $5,000. The $5,000 increase in account receivables would reduce net income by $5,000. This is because the increase in account receivable also increased net income when it was originally recorded.

Reverse impact of noncash expenses

When noncash expenses are factored into net income on the accrual basis this results in a lower amount of net income reported. Since these accounting entries do not reflect a cash outflow we must reverse those expenses by adding them back. By adding them back we are converting the net income from an accrual basis to a cash basis.

  • Add noncash expenses such as depreciation or amortization.

Example: A company buys a vehicle for $10,000 and depreciates it over 10 years. In the first year, the company recorded $1,000 depreciation expense related to the vehicle. The company will add the depreciation back to net income when preparing the statement of cash flows.

Reverse impact of gains and losses on sale of assets

When an asset is sold the amount of gain or loss is factored into the net income account when prepared on an accrual basis. Therefore, to eliminate this impact we must reverse the impact.

  • Add losses on the sale of assets
  • Deduct gains on the sale of assets

Example: A building is sold for $25,000 which was originally purchased for $20,000. The $5,000 gain is deducted from net income. The reason is because the $5,000 gain was originally added to net income when it was prepared on the accrual basis.

The following chart summarizes these adjustments based on account:

Add to Net Income Deduct from Net Income
Depreciation
Amortization of intangible assets
Decrease in receivables Increase in receivables
Losses on Assets Gains on Assets
Decrease in inventory Increase in inventory
Increase in accounts payable Decrease in accounts payable
Increase in accrued liabilities Decrease in accrued liabilities
Decrease in prepaid expenses Increase in prepaid expenses
Increase in income tax payable Decrease in income tax payable

Preparing the Statement of Cash Flows Using the Indirect Method (Comprehensive Example)[edit]

In our example, we are given an income statement and a comparative balance sheet. We will use these two financial statements to prepare our statement of cash flows. The income statement and the comparative balance sheet are shown below:

CH 16 Income Statement indirect.png


CH 16 Balance Sheet indirect.png

Calculate Net Income[edit]

The statement of cash flows using the indirect method starts with determining net income. In this case, determining net income is quite simple because we can reference the income statement to see the net income which is $2,000.

Convert the Accrual Basis Net Income Amount to Cash Basis[edit]

Our next step is to convert our net income number from the accrual basis to the cash basis. We do this by adding or subtracting noncash amounts from the amount of net income. The best method to use for this step is to analyze the financial statements to determine what section of the statement of cash flows each account should be reported on. Each account should be reported in the operating, financing, or investing section. Certain amounts might also need to be disclosed on the statement of cash flows while other amounts will not need to be included in the statement of cash flows at all.

Using the financial statements above, the following adjustments will need to be included in the operating section:

  • Depreciation Expense: The $5,000 of depreciation expense will need to be added back. When net income is calculated on the accrual basis, depreciation is subtracted which results in a reduction to net income. Depreciation is an accounting allocation and does not impact cash. Therefore, the depreciation expense is added back since it is not associated with a cash outflow.
  • Adjust for Gains and Losses: The $3,000 loss on the sale of equipment must be added back. The reason it is added back is because loss does not represent a cash outflow and it is subtracted when calculating net income. Therefore, we must add it back. If the amount was a gain then it would be subtracted. The gross proceeds from sales of assets are reflected in the investing section which includes any gain or loss.
  • Adjust for noncash current assets and current liabilities (excluding cash): Our example has two current assets and two current liabilities that are impacted by this step. The two current assets are: accounts receivable and inventory. The two current liabilities are: accounts payable and income tax payable.
    • 1. Account receivable: We have a decrease of $5,000 for accounts receivable. Whenever we have a decrease in a a current asset we add it back. The logic behind this is quite simple. If accounts receivables are decreasing then it means the customers have paid you cash to decrease the receivable. If a current asset increases then we would subtract it.
    • 2. Inventory: We have a decrease of $20,000 for inventories. If we have a decrease in a current asset then we add it back. If inventories are decreasing then that most likely means customers are buying the equipment and giving the business cash as a result.
    • 3. Accounts payable: We have an increase of $12,000 for accounts payable which is a current liability. Whenever we have an increase in a current liability we add it back. If a current liability is increasing then that means we are agreeing to pay something in the future rather than in the current period. As a result, this means we have conserved our current cash instead of spent it. The opposite holds true if we have a decrease in an current liability - we subtract it.
    • 4. Income Tax Payable: We have an increase of $5,000 for income tax payable. Since income tax payable is a current liability, the same logic is used as the accounts payable account. We must add all increases and subtract all decreases.

We did not have any accrued expenses, amortization of intangibles or prepaid expenses. These accounts are still important so we will cover them briefly:

  • Accrued Expenses: An increase in accrued expenses should be added to net income and vice versa. The reason is quite logical. If we are accruing an expense it means we are recording expenses that would otherwise require cash to be used. Instead we are not using cash to pay the expense. As a result, our cash has indirectly increased.
  • Amortization of Intangibles: Anytime we see an amortization of an intangible, we must add it back. Similar to depreciation, amortization is simply an accounting allocation method that reduces net income but does not represent a cash outflow. Therefore, it must be added back.
  • Prepaid Expenses: An increase in prepaid expenses should be subtracted from net income. The reason is because a prepaid expense represents cash being used to purchase the service (i.e. insurance, rent etc.) for future use. This results in cash being used in the current period and thus requires a subtraction from net income.

Now that we have performed our analysis, we can prepare the operating section of the statement of cash flows using the indirect method, as seen below:

CH 16 Statement of Cash Flows Indirect Example.png

As you can see from above, our cash flows from operating activities is $52,000. If we use the direct method we will calculate the same amount of cash flows from operating activities.

16.6 - Operating Section: Direct Method[edit]

The direct method provides a clearer presentation of sources of cash inflows and outflows compared to the indirect method. However, the direct method is more complicated to prepare from an accounting perspective because the data is not readily available in the accounting records. Using the direct method, the statement of cash flow must also include a supplemental section that computes operating cash flows using the indirect method. Ultimately this means it requires more work to prepare the statement of cash flows using the direct method. As a result, the direct method is not used as frequently as the indirect method. Companies can report their statement of cash flows using either method. The accounting standard setters recommend using the direct method to prepare the statement of cash flows due to providing financial statement users with more information about sources of and uses of cash flows.

The direct method is quite simple in theory: We take the operating cash inflows and then subtract the operating cash outflows. Operating cash inflows generally consist of cash received from the sale of goods, services or similar cash flows. The operating cash outflows consist of cash payments to derive the operating cash inflows. Generally, those outflows consist of cash payments to suppliers (for goods/services), general operating expenses, interest payments and taxes. We then take the cash inflows and subtract the cash outflows to calculate net cash flows from operations.

The general format of the direct method presentation is as follows:

CH 16 Statement of Cash Flows Direct Method Formula.png

Preparing the Statement of Cash Flows Using the Direct Method (Comprehensive Example)[edit]

We will now do a step-by-step example and explain each step in detail. We will use the balance sheet and income statement seen below:

CH 16 Income Statement.png


CH 16 Balance Sheet.png

Step 1: Cash Received from Customers[edit]

Cash received from customers is the amount of cash we have received from customers, as the name implies. Using our income statement, we have sales revenue of $30,000 and consulting fees of $10,000 for a total of $40,000. This amount has to be adjusted for amounts that were not actually collected from customers in cash. For example, the sales revenue could have customers who agreed to pay on trade credit. These customers will create an account receivable for the company. Remember, the income statement is prepared using the accrual basis of accounting which allows for revenues to be recorded when the sale has been substantially completed. To account for these types of transactions, we must subtract all increases in accounts receivables. We will use the following formula to do that:

Sum of Revenue Accounts - increase in Accounts Receivable or + decrease in Accounts Receivable = cash received from customers

$40,000 + $5,000 = $45,000 cash received from customers.

We add $5,000 because the accounts receivable for the period decreased by $5,000. If our accounts receivable increased then we would add that amount.

If we received interest from bonds or other investments that earn interest then we would include that amount under a separate line item below the cash received from customers line item called cash receipts of interest. It is important to note that we must factor in any interest receivable accounts. If we have an interest receivable on our balance sheet then it means the interest was not paid in cash. If we have an interest receivable account then we must subtract that amount from our interest.

If we received dividends from investments then we would handle it similar to how we handle the interest. We would report the dividends received on a line item called cash receipts of dividends. If we have a dividend receivable account then it means the dividends were not received in cash. We must subtract the amount from our dividends.

In our example we do not have interest or dividends so no separate line items are reported.

Step 2: Less Cash Payments to Suppliers[edit]

This section includes all cash payments made to acquire inventory or prepare inventory for sale. We use a special formula for calculating the amount of cash payments to suppliers, as follows:

Cost of goods sold - decrease in inventory (or + increase inventories) - increase in accounts payable (or + decrease in accounts payable) = cash paid for merchandise

10,000 - 5,000 + 2,000 = 7,000 cash paid to suppliers

We have paid $7,000 cash to suppliers.

Step 3: Less Cash Payments for General Expenses[edit]

General expenses are all expenses necessary to operate the business. We will add up all of our relevant general expense accounts and subtract any decrease in accrued liabilities. The formula below depicts this:

All General Expenses (excluding depreciation and amortization) + Decrease in Accrued Expense Payable (or - Increase in Accrued Expense Payable) = Cash Paid for Operating Expenses

$15,000 - $5,000 = 10,000 Cash Paid for Operating Expenses

The amounts used for our general expenses are wage expense, rent expense and utilities expense which equals $15,000.

Income tax payable of $5,000 is an accrued expense and must be subtracted.

Step 4: Less Cash Payments for Income Taxes[edit]

We must subtract all expenses for income taxes that were paid in cash. Our income statement includes $5,000 for income tax expense which is subtracted.

Additional Information[edit]

Unlike the indirect method of calculating operating cash flows, depreciation, amortization, gains and losses are not used in the direct method. The reason is because we are not relying on net income to calculate our operating cash flows. Instead we go directly from cash inflows from customers to subtracting the outflows directly. If you are asked to use the direct method to calculate operating cash flows don't be distracted if the question provides you amounts for depreciation, amortization, gains or loses. These amounts are distractions.

Now that we have performed our analysis, we can prepare the operating section of the statement of cash flows using the direct method, as seen below:

CH 16 Direct Method Example.png

Note: The direct method must include a supplementary schedule that includes the indirect method. We have excluded such schedule due to brevity.

16.7 - Investing Section[edit]

The investing section shows changes in cash inflows and outflows that relate to a company's long-term assets, such as, fixed assets or investments. Examples of cash inflows from investing activities include: sale of fixed assets, sale of investment securities (i.e. stocks or bonds), cash received from loans, and any related cash flows associated with the above activities. Examples of cash outflows are: purchase of fixed assets, purchase of investment securities, and lending cash in the form of loans. Unlike the operating section, there is only one method used to calculate cash flows from investing activities. That method is relatively simple and consists of adding the investing cash inflows and subtracting the investing cash outflows. The tricky part of the calculation is identifying if the cash flow is an inflow or outflow and if it is classified in the correct section (operating, investing, financing). The format of the investing cash flow section is seen below:

CH 16 Statement of Cash Flows Investing Section.png

We will now do a step-by-step example and explain each step in detail.

Step 1: Add up all Investing Cash Inflows[edit]

In order to prepare the investing section, we must be able to identify investing cash flow transactions. Typical sources of investing cash inflows include the following:

  • Sale of land or real estate for cash
  • Sale of equipment for cash
  • Sale of investment securities
  • Collection of principal on outstanding bonds or loans

Step 2: Subtract all Investing Cash Outflows[edit]

After we have identified all the investing cash inflows, we identify the outflows next. Typical cash outflows include:

  • Purchase of land of real estate
  • Purchase of equipment with cash
  • Purchase of investment securities

Preparing the Statement of Cash Flows Investing Section (Comprehensive Example)[edit]

A company has provided us with a list of transactions for the year. They have requested that you prepare their investing section of their statement of cash flows. The following list was provided:

  • Sold land for $5,000
  • Paid $500 interest on a loan
  • Purchased equipment for $3,000
  • Repaid a loan in full for $2,000
  • Sold equipment for $500
  • Purchased securities for $10,000
  • Paid dividends of $3,000

STEP 1: Classify transactions that are included in the Investing Section[edit]

Only certain transactions must be included in the investing section. Here is our analysis of the above transactions:

  • Sold land for $5,000 - This transaction is included in the investing section as a cash inflow.
  • Paid $500 interest on a loan - This transaction is NOT included in investing section. Payment of interest is included in the operating section.
  • Purchased equipment for $3,000 - This transaction is included in the investing section as a cash outflow.
  • Repaid a loan in full for $2,000 - This transaction is included in the investing section as a cash outflow.
  • Sold equipment for $500 - This transaction is included in the investing section as a cash inflow.
  • Purchased securities for $10,000 - This transaction is included in the investing section as a cash outflow.
  • Paid dividends of $3,000 - This transaction is NOT included in the investing section. It is included in the financing section.

Now that we have identified our transactions, we can prepare the investing section.

STEP 2: Prepare the Investing Section[edit]

Using the above transactions, we can prepare the investing section, as seen below:

CH 16 Investing Section Example.png

As you can see, the cash flows are negative which means the company spent more money investing compared to collecting cash from investments.

16.8 - Financing Section[edit]

The financing section of the statement of cash flows shows cash inflows and outflows related to stockholder's equity and long-term liabilities. This may sound a little bit confusing but it is not confusing if we understand what is happening in the stockholder's equity and long-term liability transactions. Stockholder's equity is included in the financing section because a company can issue new shares to raise capital for the company. This capital is helping to finance future business projects. We also include payment of dividends in the financing section. Long-term liabilities are included because a company will issue bonds or similar liabilities to help fund business projects. It is important to remember to also include payments of long-term liabilities or repurchase of shares in the financing section. Similar to the investing section, there is only one method to calculate the financing section which is to simply add up all of your financing cash inflows and subtract all of the financing outflows. The tricky part of the calculation is to be able to identify which transactions are to be included in the financing section calculation. The general format of the financing section is as follows:

CH 16 Statement of Cash Flows Financing Activities.png

We will now do a step-by-step example and explain each step in detail.

Step 1: Add up all Financing Cash Inflows[edit]

For this section we simply need to identify financing cash inflows. The following are sources of financing cash inflows:

  • Issuance of bonds or loans to borrow cash from investors.
  • Issuance of the company's stock in exchange for cash.

Step 2: Subtract all Financing Cash Outflows[edit]

For this section we simply need to identify financing cash outflows. The following are sources of financing cash outflows:

  • Repayment of bonds or loans
  • Dividends paid in cash
  • Purchase of treasury stock

The last bullet point might seem a little strange. Treasury stock is the company's stock that was repurchased from investors. In this type of transaction, the company uses cash or similar assets to repurchase the company's own stock. This is a way to return cash to owners, similar to a dividend and is classified as a financing cash outflow if cash was used to purchase the stock.

Preparing the Statement of Cash Flows Financing Section (Comprehensive Example)[edit]

A company has provided us with a list of transactions for the year. They have requested that you prepare their financing section of their statement of cash flows. The following list was provided:

  • The company issued stock and raised $5,000
  • The company repurchased its own stock (treasury stock) for $3,000
  • The company repaid an outstanding bond with $2,000
  • The company paid a dividend of $3,500
  • The company issued bonds worth $10,000
  • The company paid interest of $2,500

STEP 1: Classify transactions that are included in the Financing Section[edit]

Only certain transactions must be included in the financing section. Here is our analysis of the above transactions:

  • The company issued stock and raised $5,000 - This transaction would be included in the financing section as a cash inflow.
  • The company repurchased its own stock (treasury stock) for $3,000 - This transaction would be included in the financing section as a cash outflow.
  • The company repaid an outstanding bond with $2,000 - This transaction would be included in the financing section as a cash outflow.
  • The company paid a dividend of $3,500 - This transaction would be included in the financing section as a cash outflow.
  • The company issued bonds worth $10,000 - This transaction would be included in the financing section as a cash inflow.
  • The company paid interest of $2,500 - This transaction would NOT be included in the financing section. It is included in the operating section.

Now that we have identified our transactions, we can prepare the financing section.

STEP 2: Prepare the Financing Section[edit]

Using the above transactions, we can prepare the financing section, as seen below:

CH 16 financing section example.png

As you can see, the cash flows are positive which means the company had a net positive cash inflow from financing.

16.9 - Disclosure of Noncash Activities[edit]

Noncash activities often impact the financing and investing section of the statement of cash flows. These are transactions which indirectly impact cash inflows or outflows and don't directly impact cash. In other words, for these transactions there is no exchange of cash. For example, a company could issue stock to retire a bond. The company could also purchase assets with stock, exchange noncash assets, or convert debt to stock. All of these transactions could impact a financial statement user's decision and therefore they should be disclosed. The disclosure is most often made at the bottom of the statement of cash flows. The disclosure could also be made in a separate schedule as long as it accompanies the statement of cash flows. The following is an example of a typical schedule of noncash financing and investing activities:

CH 16 NonCash Financing and Investing Activities.png

16.10 - Statement of Cash Flows Financial Ratios and Analysis[edit]

Financial analysts and other users of the statement of cash flows can use ratio analysis to better understand the statement. We will be reviewing two different types of ratios, which are: operating cash flow, and cash debt coverage. As an important reminder, cash flow per share is not reported on the statement of cash flows because it would be misleading.

Operating Cash Flow[edit]

The operating cash flow ratio measures the amount of cash flow from operating activities relative to current liabilities. This ratio is significant because for a company to continue operating into the foreseeable future, they will need to be able to pay their current liabilities as they come due. The operating cash flow ratio is a liquidity ratio and it can be used to evaluate if a company is a going concern (at risk of failure). Below is the formula for the operating cash flow ratio:

Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

If the ratio is below 1 then it means the company is at risk of not being able to meet its current liabilities as they come due. If the company cannot meet their current liabilities then they will need to consider financing or raising capital from owner's or investors. The higher the operating cash flow ratio, the better.

Example:

Bob Smith Motors has $23 million in operating cash flows based on his statement of cash flow for the year ended 2017. The current liabilities based on the 2017 balance sheet reports $56 million. The operating cash flow ratio would be calculated as follows:

Operating Cash Flow Ratio = $23,000,000 / $56,000,000

The ratio equals 0.41

The ratio of .41 means that the company will take a little under 2 and half years to repay all of the current liabilities if the company devoted all of the operating cash flows to repaying the current liabilities. If this company had business issues that impact the operating cash flows then the business would have an issue with meeting current liabilities as they come due.

Cash Debt Coverage[edit]

The cash debt coverage ratio shows how much operating cash flow the company is generating compared to the company's total debt. This ratio shows how long it would take for the company to repay its total debt from operating cash flow, excluding interest expense. The higher this ratio, the faster the company will be able to repay the total debt outstanding. If the company has a ratio of 1 then it means the company can repay all of the debt in 1 year, assuming all operating cash flow went to debt repayments. The formula for the cash debt coverage ratio is shown below:

Cash Debt Coverage = Operating Cash Flow / Average Total Liabilities

Example:

Bob Smith Steel Corporation had operating cash flows of 2 million on the 2017 statement of cash flows. At the beginning of the year, the corporation had 1.5 million in total liabilities and at the end of the year the firm had 1.75 million in total liabilities.

In order to calculate the cash debt coverage ratio, we must first find the average total liabilities. To do this, we simply add the beginning of the year total liabilities to the end of the year total liabilities and divide by 2. Our calculation would be: (1.5 million + 1.75 million)/2 which equals 1.625 million. Calculating the ratio is simple after this:

Cash Debt Coverage = 2 million / 1.625 million

Our ratio equals 1.23

This ratio means the firm can repay all of its average total liabilities in less than one year because the ratio is higher than 1. If the ratio was lower than one then it would mean the firm would take longer than one year to repay all of the average total liabilities.