ACCT90002 Chap.5 Ratios and Cash Flow Diagnosis
Ratios and Cash Flow Diagnosis
Ratio analysis is a connected diagnostic system. Profitability asks whether operations generate adequate return, efficiency asks how intensely resources are used, liquidity focuses on near-term claims, and solvency considers the longer-run financing burden. Cash-flow analysis tests whether accrual profit converts into cash, how much cash is reinvested and how any gap is financed.
Ratios gain meaning through comparison across time, peers, strategy or an explicit threshold. Definitions, year ends, averages, policy choices and unusual items must be aligned first. The indirect cash-flow bridge begins with net income, adds non-cash charges and adjusts for working capital. An increase in an operating asset uses cash; an increase in an operating liability provides cash.
Free cash flow then requires a stated definition and context. Negative cash after investment can support valuable growth, while positive cash can reflect maturity or underinvestment. This chapter joins the measures into one repeatable diagnostic route.
What this chapter covers
- 01
Profitability lens: connect margins and returns with operating drivers and accounting quality
- 02
Efficiency lens: use turnover and days measures to examine resource intensity and working-capital control
- 03
Liquidity lens: compare near-term claims with cash, receivables, inventory quality and facilities
- 04
Solvency lens: combine leverage, coverage, maturity and the loss-absorbing capacity of equity
- 05
Operating-cash bridge: reconcile accrual profit through non-cash items and working-capital movements
- 06
Investing cash: separate maintenance, growth, acquisitions, disposals and financial investments
- 07
Financing cash: trace borrowing, repayment, equity transactions and distributions
- 08
Repeatability test: distinguish customer cash from temporary release, asset sales or external financing
Worked example · free
Reconcile profit to operating cash
- 1Begin with net income of 60 and add back non-cash depreciation of 18 to reach 78.
- 1Subtract the receivables increase of 12 because sales have not yet produced cash.
- 1Subtract the inventory increase of 9 because additional stock used cash.
- 1Add the payables increase of 5 because suppliers temporarily funded operations.
- 1Operating cash flow = 60 + 18 - 12 - 9 + 5 = 62; conversion is 62 divided by 60 = 103.3%.
Key terms
- Current ratio
- Current assets divided by current liabilities, a broad measure of near-term balance-sheet coverage.
- Quick ratio
- Liquid current assets divided by current liabilities, excluding inventory and other less immediate resources.
- Cash conversion
- The relationship between operating cash flow and accrual profit, interpreted through non-cash and working-capital drivers.
- Receivable days
- A collection-speed measure connecting receivables with credit sales over a stated period.
- Capital expenditure
- Cash invested in long-term operating assets, requiring interpretation as maintenance, growth or replacement.
- Cash headroom
- Cash available after identified operating, investment, financing or contractual requirements.
Ratios and Cash Flow Diagnosis FAQ
Can one ratio support a conclusion?
Rarely. A ratio needs a relevant benchmark, a mechanical driver, an economic explanation and a cash or risk check. Profitability, efficiency, liquidity, solvency and cash measures can move in different directions and should be read together.
Why can operating cash exceed net income?
Non-cash charges such as depreciation are added back, and working-capital release can supply cash. The analyst separates those sources because strong customer cash is more repeatable than delayed payments to suppliers or inventory liquidation.
Is positive free cash flow always favourable?
No. It can reflect mature cash generation, but it can also result from underinvestment or a temporary working-capital release. The definition, lifecycle, maintenance needs, growth opportunities, financing and distributions determine the interpretation.
Why does an inventory-heavy current ratio need caution?
Inventory may be slow, obsolete or difficult to sell at carrying value before liabilities fall due. Compare the quick ratio, ageing, turnover, seasonality, cash timing and available facilities before judging short-term liquidity.
Exam move
Create a one-page sign guide for receivables, inventory and payables, then practise the indirect cash bridge until every direction is automatic. Group ratios by the question they answer rather than memorising a long list. For each measure, record its numerator, denominator, appropriate average, benchmark and main accounting trap.
When working a cash-flow problem, keep operating, investing and financing layers separate and state the definition of free cash flow you use. Inspect offsetting working-capital movements rather than relying only on the net total. Finish with repeatability: identify whether cash came from customers, reduced investment, asset sales, supplier delay, new borrowing or equity.
That final classification turns a cash calculation into a diagnosis of performance and risk. Pair every ratio dashboard with a cash bridge for the same period. Circle signals that agree and investigate signals that conflict, such as rising profit with deteriorating collections. Compare both the level and the trend with a relevant benchmark, then state which movement is operational, temporary or financing-supported.
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