Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 7 Sarbanes-Oxley, Internal Control, and Cash 327

Banks may require companies to maintain minimum cash balances in their bank

accounts. Such a balance is called a compensating balance. This requirement is often

imposed by the bank as a part of a loan agreement or line of credit. A line of creditis a

preapproved amount the bank is willing to lend to a customer upon request. If signif-

icant, compensating balance requirements should be disclosed in notes to the financial

statements.

CASH RATIOS

Analyzing cash and cash flows is essential to interpreting financial statements.

The statement of cash flows reports cash flows from operating, investing, and financ-

ing activities. In addition, two cash ratios useful for analyzing and interpreting oper-

ating performance are (1) cash flow to net income and (2) cash to monthly cash

expenses.

Ratio of Cash Flow to Net Income

The accrual basis of accounting is used by all public companies in determining and re-

porting net income. As we illustrate throughout this text, accrual accounting records

revenues when earned and expenses when incurred and not necessarily when cash is

received or paid. This process gives rise to accruals and deferrals that are updated and

adjusted at the end of each reporting period. As a result, net cash flows from opera-

tions is rarely the same as net income.

When the amount of accruals and deferrals is large, the difference between net

cash flows from operations and net income will also be large. The effect of accruals and

deferrals on net income can be measured by the ratio of net cash flows from operations

to net income. Accordingly, significant changes in this ratio from year to year should

be investigated for the underlying causes. For example, implementing a new account-

ing standard may significantly affect net income and comparability between years.

Likewise, management could change methods of estimating and recording accruals,

deferrals, and depreciation. Such changes also affect the current period’s net income

comparability with prior years.

The ratio of cash flow to net income is computed as follows:

Ratio of Cash Flow to Net Income 

Net Cash Flows from Operations

Net Income

To illustrate, the ratio of cash flow to net income for The Walt Disney Company

for 2004 and 2003, respectively, is shown below. Amounts are in millions.

2004 2003

Net cash flows from operations $4,370 $2,901

Net income $2,345 $1,267

Cash flow ratio 1.86 2.29

The cash flow ratio declined from 2.29 in 2003 to 1.86 in 2004. Cash flows from

operations increased at a smaller relative amount than did the net income. Why did

Describe, illustrate, and in-
terpret the cash flow to net
income ratio and the cash
to monthly cash expenses
ratio.

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