298 Accounting: Business Reporting for Decision Making
It is often argued that the cash flow ratio is a better measure of liquidity than the current ratio because
it utilises cash flow generated over a whole reporting period rather than the current assets at a particular
point in time. Examining the trend in the cash flow ratio over the ten years, as shown in figure 7.4, again
reveals an improvement after the 2005 year when there were major investments in other businesses.
JB Hi-Fi Ltd probably hoped that the large investments in 2005 would generate higher cash flows from
operations in future years. However, the ratio declined again in 2008. In this year a significant payment
was made for businesses, but the slump probably also points to the risky nature of the electronics busi-
ness environment and the start of the global financial crisis. A point worth noting in relation to liquidity
is that it is trying to measure an entity’s ability to meet its short-term obligations.
Debt coverage ratio
The debt coverage ratio links the cash flows from operating activities to long-term debt (in contrast to
the cash flow ratio, in which the link is to short-term liabilities). This ratio is a measure of an entity’s
ability to survive in the longer term and remain solvent. As seen in figure 7.5, the debt coverage ratio of
JB Hi-Fi Ltd in 2015 was 0.95 times or 95 per cent. This informs us that, at the current operating level
(i.e. if cash from operations remains constant), it would take 0.95 years to repay the existing long-term
debts. This can be compared to previous years, and also to the current loan term. Again, the comparison
between the ratios over the years, as shown in figure 7.4, indicates a fluctuating performance. This can
be linked to the weak collection of receipts and the large capital investment in 2005 and the large debt
acquired during 2011.
Cash flow to sales ratio
The cash flow to sales ratio measures the relative amount of cash flow generated by each sales dollar. It
is used to help interpret the profitability of an entity. As shown in figure 7.5, the cash flow to sales ratio
of JB Hi-Fi Ltd in 2015 was 0.05 times or 5 per cent. This means that for every sales dollar received, the
entity generated an operating cash flow of 5 cents. Again, this ratio needs to be compared with the previous
years’ ratios to determine whether it is reasonable. It also should be compared to the equivalent accrual-based
ratio of return on sales, which is calculated by profit divided by net sales. (The entity’s return on sales was
0.037 times in 2015, and also 0.037 times in 2014.) Any significant differences should be investigated.
JB Hi-Fi Ltd’s cash flow to sales ratio has been steady over the last ten years, as shown in figure 7.4.
Although ratios help with the evaluation of financial statements, they do not stand alone. They need to
be interpreted in light of other ratios, compared with past ratios and industry ratios (e.g. manufacturing
industries tend to have higher capital expenditures than service industries), and considered with other
information presented in the financial statements.
Free cash flow
Another indicator of performance sometimes used is free cash flow, which represents the free cash a
company has available to repay debt, pay dividends and expand operations. The measure is calculated
by taking the amount spent on capital investments for property, plant and equipment to maintain existing
operations, and subtracting it from the cash from operating activities. For JB Hi-Fi Ltd, free cash flow
for 2015 was $137.4 million (compared to $5.4 million in 2014). (Note that, in calculating this figure,
the payment for property, plant and equipment was assumed to be for maintaining existing operations.)
There are a number of different definitions and calculations for free cash flow so, if this performance
indicator is reported by an entity, it is important to understand how it was calculated. One drawback of
the calculation is that it is difficult to assess how much of the capital investment in property, plant and
equipment is to maintain existing operations, and how much is for expansion. For JB Hi-Fi Ltd, the
$42.5 million payment in 2015 probably includes some capital expenditure for expansion, and thus this
portion should be excluded from the calculation. Unfortunately, the information in the statement of cash
flows does not distinguish between the two. The comparison of the free cash flow over the years, as pre-
sented in figure 7.5, should bear this in mind as the free cash flow fluctuates when significant expansion
(e.g. in 2005 and 2008) occurs.