Cash Flow Statement Analysis: Cash Flow Ratios for CFA Exam
Introduction
Analyzing cash flow statements is essential for assessing a company’s liquidity, solvency, and overall financial health. In the exam, understanding cash flow ratios helps candidates evaluate a company’s ability to generate cash, meet obligations, and sustain operations. These ratios are divided into performance (profitability) ratios and coverage (solvency) ratios.
1. Performance Ratios
Performance ratios measure the efficiency of cash generation relative to revenue, assets, and equity. These ratios help assess how well a company converts its sales and investments into cash.
Key Performance Ratios
| Ratio | Formula | Interpretation |
|---|---|---|
| Cash Flow to Revenue | CFO ÷ Net Revenue | Cash generated per dollar of revenue |
| Cash Return on Assets | CFO ÷ Average Total Assets | Cash generated per dollar of assets |
| Cash Return on Equity | CFO ÷ Average Shareholders’ Equity | Cash generated per dollar of equity investment |
| Cash to Income | CFO ÷ Operating Income | Cash-generating ability of operations |
| Cash Flow Per Share | (CFO – Preferred Dividends) ÷ Common Shares Outstanding | Cash flow available per common share |
Interpretation:
- A higher ratio indicates strong cash-generating ability, making the company more efficient in turning revenue into cash.
- A lower ratio may signal inefficiency or potential liquidity problems.
2. Coverage Ratios
Coverage ratios assess a company’s ability to meet financial obligations, including debt payments, interest, and reinvestment in assets.
Key Coverage Ratios
| Ratio | Formula | Interpretation |
| Debt Coverage | CFO ÷ Total Debt | Financial risk and leverage assessment |
| Interest Coverage | (CFO + Interest Paid + Taxes Paid) ÷ Interest Paid | Ability to meet interest obligations |
| Reinvestment | CFO ÷ Cash Paid for Long-Term Assets | Ability to invest in assets using cash flow |
| Debt Payment | CFO ÷ Cash Paid for Long-Term Debt | Ability to pay debt using cash flow |
| Dividend Payment | CFO ÷ Dividends Paid | Ability to pay dividends with operating cash flow |
| Investing & Financing | CFO ÷ Cash Outflows for Investing and Financing Activities | Ability to fund investments, debt, and dividends |
Interpretation:
- A higher ratio indicates a stronger ability to cover debt, interest, and reinvestment needs.
- A lower ratio may suggest liquidity constraints and financial distress.
3. Special Considerations in IFRS and US GAAP
- Under IFRS, total dividends paid might be included as an operating cash outflow. In such cases, add back total dividends to CFO before subtracting preferred dividends when calculating cash flow per share.
- Interest paid is classified differently under IFRS and US GAAP:
- If interest paid is included in financing cash flows (IFRS), do not add it back in the interest coverage ratio calculation.
- Under US GAAP, interest paid is classified under operating activities, making comparisons with IFRS-based statements important.
4. Example Questions and Solutions
Question 1: Interest Coverage Ratio
An analyst has calculated a ratio using as the numerator the sum of operating cash flow, interest, and taxes and as the denominator the amount of interest. What is this ratio, what does it measure, and what does it indicate?
A. This ratio is an interest coverage ratio, measuring a company’s ability to meet its interest obligations and indicating a company’s solvency.
B. This ratio is an effective tax ratio, measuring the amount of a company’s operating cash flow used for taxes and indicating a company’s efficiency in tax management.
C. This ratio is an operating profitability ratio, measuring the operating cash flow generated accounting for taxes and interest and indicating a company’s liquidity.
Solution: The formula used in the question is:
This is a cash-based interest coverage ratio, which measures a company’s ability to generate sufficient cash to cover its interest payments. A higher ratio indicates stronger solvency and financial health, while a lower ratio suggests potential difficulties in meeting debt obligations.
✅ Answer: A. This ratio is an interest coverage ratio, measuring a company’s ability to meet its interest obligations and indicating a company’s solvency.
Question 2: Cash-to-Income Ratio
The following financial statement data are available for a company:
| Metric | $ thousands |
| Operating income | 3,390 |
| Net income | 2,210 |
| Operating assets | 3,850 |
| Change in cash and cash equivalents | 1,010 |
| Change in cash from operating activities | 1,750 |
| Free cash flow to the firm | 2,240 |
The company’s cash-to-income ratio is closest to:
A. 0.79
B. 0.66
C. 0.52
Solution: The cash-to-income ratio is calculated as:
Given:
- CFO = 1,750
- Operating Income = 3,390
✅ Answer: C. 0.52
Question 3: Common-Size Cash Flow Statement
One appropriate method of preparing a common-size cash flow statement is to show each line item:
A. of revenue and expense as a percentage of net revenue.
B. on the cash flow statement as a percentage of net revenue.
C. on the cash flow statement as a percentage of total cash outflows.
Solution: A common-size cash flow statement expresses each cash flow item as a percentage of a common base figure, typically net revenue (sales). The correct approach is:
✅ Answer: B. on the cash flow statement as a percentage of net revenue.
