ACCT1101 Chap.7 Cash Flow Ratios and Warning Signs
Cash Flow Ratios and Warning Signs
Once a statement of cash flows exists, it becomes a source of ratios that say things the profit statement cannot.
All of them are built on the same numerator, cash from operating activities, and they differ only in what that figure is compared against, which makes them far easier to learn than they first appear.
The cash adequacy ratio divides cash from operating activities by capital expenditure plus dividends paid, and it asks whether trading generates enough cash to reinvest in the business and reward the owners.
Above one, or one hundred per cent, means it does. The cash flow ratio divides cash from operating activities by current liabilities and is a liquidity measure: it asks how much of what falls due within the year a year of trading cash would cover.
The debt coverage ratio inverts the comparison, dividing non current liabilities by cash from operating activities, and is read as a solvency measure of how many years of trading cash the long term debt represents. The cash flow to sales ratio divides cash from operating activities by net sales, and reports how many cents of operating cash each sales dollar produced.
Free cash flow is not a ratio at all but a dollar figure: cash from operating activities less the capital investment needed to maintain existing operations.
The course also gives a list of warning signs to read off the statement itself.
Trading that consumes cash instead of producing it, a net figure that keeps falling, customer receipts smaller than what goes out to suppliers and staff, operating cash sitting below profit after tax, day to day activity being funded from share issues, investing inflows that come and go without a pattern, and borrowings that keep outrunning repayments.
Each of these is a question to ask rather than a verdict to deliver, and a good answer says what would confirm the concern.
What this chapter covers
- 01
Why every cash ratio shares the same numerator
- 02
Cash adequacy: reinvestment and distributions covered by trading
- 03
Cash flow ratio as a liquidity measure against current liabilities
- 04
Debt coverage as a solvency measure over the longer term
- 05
Cash flow to sales, and what it adds to a margin
- 06
Free cash flow as a dollar amount rather than a ratio
- 07
The warning signs list and how to phrase a concern as a question
- 08
What managers can do when cash is short, and when it is abundant
Five figures, four readings, one recommendation
- +1Cash adequacy is operating cash over capital expenditure plus dividends, so $1.86m divided by $2.70m gives 0.69 times, or 69 per cent. Because it is below one, trading is not currently funding both the reinvestment and the distribution.
- +1Cash flow ratio is operating cash over current liabilities, so $1.86m divided by $3.10m gives 0.60 times. Debt coverage is non current liabilities over operating cash, so $5.58m divided by $1.86m gives 3.0 times, meaning roughly three years of trading cash would be required to retire the long term debt.
- +1Cash flow to sales is operating cash over net sales, so $1.86m divided by $24.80m gives 0.075, or seven and a half cents of operating cash for every sales dollar. Free cash flow is operating cash less capital investment, so $1.86m less $2.40m gives negative $0.54m.
- +1State one concern and make it checkable. The capital programme and the dividend together exceed the cash the business generated, so the shortfall was funded from somewhere else. The confirming evidence is in the financing section: if borrowings rose by about the shortfall, the expansion is being carried by debt while a dividend is still being paid out.
Key terms
- Cash adequacy ratio
- Cash from operating activities divided by capital expenditure plus dividends paid, showing whether trading funds reinvestment and distributions.
- Cash flow ratio
- Cash from operating activities divided by current liabilities, used as a liquidity measure.
- Debt coverage ratio
- Non current liabilities divided by cash from operating activities, read as how many years of trading cash the long term debt represents.
- Cash flow to sales ratio
- Operating cash set against net sales, which reports how many cents of cash each sales dollar actually produced.
- Free cash flow
- Cash from operating activities less the capital investment required to maintain existing operations, expressed as a dollar amount.
Cash Flow Ratios and Warning Signs FAQ
Why do so many of these ratios use operating cash rather than profit?
Because profit contains accrual judgements and operating cash does not. Revenue recognised on credit, an allowance for doubtful debts and a depreciation policy all move profit without moving money. Comparing obligations against cash actually generated by trading removes those judgements from the comparison, which is the whole point of having a second family of ratios.
Is a cash adequacy ratio below one always a problem?
Not by itself. A business making a deliberate, one off investment will show a low figure for that year and a normal one afterwards, so the reading depends on the trend and on what the capital expenditure was for. What turns it into a problem is a run of years below one alongside rising borrowings, because then the shortfall is being funded rather than earned.
What does it mean when operating cash is below profit after tax?
It means the profit is not converting into money, and the usual causes are visible on the statement of financial position: receivables rising because customers are slower to pay, or inventory rising because goods are not moving. The course lists both of those as warning signs in their own right, so a good answer names the cause it would look for rather than stopping at the observation.
What can a manager actually do about a cash shortage?
The course sets out practical levers on both sides. On the collections side, tighten the terms offered, put a ceiling on any one customer's account balance, or make paying early worth a discount. On holdings, reduce the amount of inventory carried. On funding, use supplier credit where it is available, borrow where future cash flows support repayment, or issue further shares.
And if there is too much cash?
Then the question becomes the opportunity cost of holding it. The options named are to reassess strategy and expand, to invest in additional assets, or to pay down debt. Cash sitting idle earns little, so leaving a large balance untouched is itself a decision that a reader of the statements may reasonably ask about.
Exam move
Write the five formulas once, in a single column, and notice that four of them start with the same number. Then learn them by what they are compared against rather than as five separate things: reinvestment plus dividends, current liabilities, long term liabilities, and sales.
That structure survives exam pressure far better than five memorised fractions.
Spend the rest of your time on interpretation, because that is where this topic is assessed. Take any published set of statements, compute the five figures, and write four sentences: what the number is, what it measures, what would make it move, and what you would look at next.
Four sentences is roughly the length of answer these questions expect.
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