Business Education
Understanding Cash Flow








How are Cash Flow Ratios Compiled ?

What is Cash Flow ?

Cash flow is the ability of a business firm to pay its debt obligations and to expand its business operations using its net earnings plus depreciation. This is an extremely important finance function since cash is the lifeblood of any on-going business concern. Without adequate cash flow, even a profitable company could conceivably go out of business. Basically, a company needs cash to sustain its ability to stay in business.

At USBR, we've coined the term "cash flow ratios" to refer to ratios used to calculate a firms' ability to pay future debt obligations. We believe this will give the reader a new and insightful way of assessing a company's financial strength.


Cash Flow vs. Earnings : What's the Difference ?

Companies report earnings on an accrual basis which reflects costs and expenses over a stated period of time. This is normally every quarter and also on an accumulative annual basis. These reported figures DO NOT take into consideration the cash receipts of the company. For instance, recording depreciation charges as an expense on their income statment which reflects the amount that needs to be allocated for the current period of time even though the fixed asset was purchased in prior periods -- possibly for cash.

Corporations have wide latitude to manipulate their earnings to the investment commmunity and make their financial figures appear better than they really are. This is a major flaw with General Accepted Accounting Principles (GAAP). For instance, MCI (formerly Worldcom) inflated its earnings simply capitalizing and deferring rather than expensing $3.9 billion of its leased network access costs which had previously been treated as an expense. Earnings can also ignore changes in work capital and do not consider the amount of required capital investment in a project. In addition, some technology companies have short lived assets which can substantially impair cash flow.


How to Measure Cash Flow.

There are several financial components that are considered when determing total cash flow. This can include depreciation, amortization, and other non-cash items. These three figures mentioned are added to net income. Figures to be deducted include capital expenditures, cash dividends, and changes in working capital are added as well.(see Table 2.3 below)

Table 2.3
Cash Flow Calculations
Net Income + (Plus)
Depreciation + (Plus)
Amortization + (Plus)
Other Non-Cash Charges + (Plus)
Net Cash =
CapEx - (Minus)
Cash Dividends - (Minus)
Chg in Working Capital - (Minus)
Cost of Acquisitions - (Minus)
Proceeds from Disposals - (Minus)
PreFinancing Cash Flow =

Focusing on debt service coverage and free operating cash flow is more critical with the analysis of a small or financially weak entity.However, more emphasis should be placed on the relationship between funds from operations ( operating activities) and long term debt for a more larger, more mature, and financially sound company.


Case Studies in Action

Suppose Celerex Corp., a chemical producer, decides to upgrade its industrial capacity.The company has spent $2 billion dollars expanding its plant and equipment over the past four years. Accounts receivables grew to $550 million dollars in 2004 from $376 million in 2003. Inventories rose by $80 million.