Hmm…

Balance sheet ratios…

It’s one of the first set of ratios and methods you learn to use when analyzing a company.

- Current and Quick Ratio
- Debt to Equity
- Return on Equity
- and so on

Very popular and common.

Now the balance sheet ratios focuses on drilling down into the financial health of a company at a single point in time.

[drizzle]

But when it comes to doing a liquidity or solvency analysis, using the cash flow statement is a much better indicator than using the balance sheet or income statement ratios.

Gross margins are important but it doesn’t tell you anything about whether a company can survive or not.

The PE isn’t much help too.

However, like most important things, cash flow statement analysis gets pushed down to the bottom of the list of things to look at and analyze.

The income statement has a lot of non cash numbers like depreciation and amortization which doesn’t affect cash flow. It’s also an accrual method which doesn’t match the exact cash in and outflow.

Now, the balance sheet data is only for a single point in time.

So it’s not that helpful in trying to figure out a consistent going concern analysis.

There have been lots of companies where the balance sheet looked fine one quarter, but then investors are met with a huge surprise as debt balloons, cash dives and the company falls into dangerous territory.

But the cash flow statement works to untangle bookkeeping numbers and the changes from the other two statements to give a number that you really care about.

CASH.

As much as Wall Street loves earnings, the core engine behind a business and earnings is really cash.

Cash creates earnings.

Earnings does not create cash.

If a business doesn’t have cash and can’t maintain liquidity, there will be no earnings.

Let’s dig into some of those juicy cash flow ratios.

I do not use all of these ratios in the **OSV Stock Analyzer** as I don’t see the necessity of using all of them.

The purpose here is to provide as much information and detail as possible to cover all bases. That way, you can try it out yourself and see what works for you.

There are some new ones that I’ll be looking into further though.

For all ratios, it’s important to compare the ratios between competitors. Numbers across industries will vary so make sure you are comparing apples to apples.

#### Operating Cash Flow Ratio

**Cash Flow from Operations (CFO) /Sales**

Using FCF instead of Operating Cash Flow is a variation that you can apply to most of the cash flow statement ratios you see here.

For this ratio, it shows you how many dollars of cash you get for every dollar of sales.

Unlike most balance sheet ratios where there is a certain threshold you want to look for (BV < 1 for cheapness, debt to equity ratio < 1 etc), there is no exact percentage.

The higher the percentage the better as it shows how profitable the company is.

**Tip:** Make sure that the operating cash flow increases in line with sales over time. You don’t want to see it deviate from each other too much as it’s a sign of weakness and inconsistency.

**Alternatives:** FCF/Sales

#### Asset Efficiency Ratio

**CFO / Total Assets**

Similar to ROA, but uses cash flow from operations instead of net income.

This is a basic ratio to show you how well the company uses its assets to generate cash flow.

It’s best used to view the historical trend as well as to compare with competitors.

**Tip:** Instead of Total Assets, the ratio can be cleaned up by using just PP&E.

**Alternatives:** CFO / PP&E

#### Current Liability Coverage Ratio

To test for solvency, this is a simple ratio.

**CFO / Current Liabilities**

**or**

**(CFO – Dividends Paid) / Current Liabilities**

The more accurate method is to subtract the cash used to pay off dividends as it will give a truer picture of the operating cash flows.

This ratio gives you an idea about the company’s debt management practices.

E.g. a value of 4.3 means that the current cash flows can pay for 4.3x the current liabilities.

The higher the number the better. If it drops below 1, then CFO is unable to pay the current liabilities.

It’s also a better indicator of the company’s ability to pay current liabilities than the current ratio or quick ratio.

**Tip:** This ratio is used to analyze the short term stability of a company. This ratio also includes the current maturing portion of long term debt.

**Alternatives:**

- CFO/Short Term Debt
- FCF/Current Liabilities
- FCF/Short Term Debt

#### Long Term Debt Coverage Ratio

**CFO / Long Term Debt**

**or**

**(CFO – Dividends Paid) / Long Term Debt**

If you have a ratio for short term liabilities, then it makes sense to have one for long term debt.

A common error is bunching up all forms of debt without splitting it up.

That’s why if you just use the Debt/Equity ratio only, you should start looking at Short Term Debt/Equity and Long Term Debt/Equity.

But again, using cash flow numbers gives you an immediate sense of whether the company can pay off the debt.

The higher the number, the more cash from operations the company has to pay off debt.

If the ratio is trending down, management may raise more capital via dilution or more debt.

**Alternatives:**

- FCF/Long Term Debt

#### Interest Coverage Ratio

**(CFO + Interest Paid + Taxes Paid) / Interest Paid**

The multiple you get from this ratio shows you the company’s ability to make the interest payments on its entire debt load.

A highly leveraged company will have a low multiple.

A company with a strong balance sheet will have a high multiple.

If the interest coverage is less than 1, the company has a high risk of default.

**Alternatives:**

By substituting CFO for FCF in this equation, it tells you whether the company is able to pay off the interest from it’s FCF. FCF has to be positive for this to work of course.

- (FCF + Interest Paid + Taxes Paid) / Interest Paid

#### Cash Generating Power Ratio

**CFO / (CFO + Cash from Investing**

*Inflows*+ Cash from Financing*Inflows*)I love the name of this one.

It’s a new one for me, but it’s designed to show the company’s ability to generate cash purely from operations compared to the total cash inflow.

Instead of using the entire cash from investing activities and cash from financing activities, only the **inflows** is used.

E.g. Here’s a snapshot of AMD’s cash flow statement for the past 2 years and the TTM.

The red rows are the numbers that are used for this ratio. It’s obviously easier if everything is organized for you like what’s provided in the **OSV stock analyzer **because you’re not using the net value.

AMD has bad numbers in this area due to all the cash losses.

- 2012: -60.1%
- 2013: -33%
- TTM: -20.5%

These numbers are horrible, but there is improvement.

It also shows that AMD can’t generate cash from operations alone and the investing and financing cash inflows really help.

Now take a look at INTC.

- 2012: 37%
- 2013: 126.7%
- TTM: 88%

I know which company I’d prefer to buy.

#### External Financing Index Ratio

**Cash from Financing / CFO**

This ratio compares the cash flow from financing activities with cash from operation to show how dependent the company is on financing.

The higher the number, the more dependent the business is on external money.

The strongest companies like MSFT and INTC have negative ratios because they are able to pay back stock or debt so the net cash from financing is negative.

On the other hand, AMD is also negative, but for the wrong reasons.

Cash from Financing is positive and cash from operations is negative which is a red flag.

[/drizzle]