Accounting Business Reporting for Decision Making

CHAPTER 7 Statement of cash flows 297

Ratio analysis is a method to help the user interpret key items in the financial statements in order to

assess the health of an entity. Normally, one key amount is divided by another key amount for the pur-

pose of expressing their relationship as a ratio or percentage. The concept of ratio analysis, as it applies

to information in the statement of cash flows, will be discussed further in chapter 8. However, to com-

plete our evaluation of the statement of cash flows, some relevant ratios are presented in figure 7.5 and

discussed in the following sections.

Ratio Calculation JB Hi-Fi Ltd for 2015

Cash adequacy ratio Cash from operating activities

Capital expenditure + Dividends paid

$179 896

$42 466 + $87 174

= 1.39 times or 139%

Cash flow ratio (liquidity) Non-current liabilities

Cash from operating activities

$179 896

$380 336

= 0.47 times or 47%

Debt coverage ratio

(solvency)

Cash from operating activities

Current liabilities

$171 198

$179 896

= 0.95 times or 95%

Cash flow to sales ratio

(profitability)

Cash from operating activities

Net sales

$179 896

$3 652 136

= 0.05 times or 5%

Free cash flow Cash from operating activities − Capital $179 896 − $42 466 = $137 430

investments for property, plant and equipment to maintain existing operations

FIGURE 7.5 Cash-based ratio analysis

Source: Information from JB Hi-Fi Limited 2015, preliminary annual report.

Cash adequacy ratio

The cash adequacy ratio expresses the cash flows from operating activities as a percentage of the

capital expenditure plus dividends paid for the period. In other words, the ratio shows an entity’s

ability to reinvest in its operations and to make distributions to owners from its operating cash flow.

The cash adequacy ratio for JB Hi-Fi Ltd over the period 2005 to 2015 is calculated in figure 7.4.

It shows that cash from operating activities could cover the current capital investment and dividends

1.39 times in 2015. A ratio greater than 1 over several years suggests good performance. The trend

for JB Hi-Fi Ltd shows that the cash adequacy ratio has fluctuated over the period since 2005. In

2005 it was negative. An investigation into this financial statement reveals that new businesses were

acquired at a cost of almost $22 million. Investors inspecting the cash adequacy ratio after 2005

would have been happy to see positive ratios as they show that the purchases improved future cash

flow. However, in 2011 the ratio again slipped below 1. As discussed in the previous section, there

was a large dividend paid. The dividend paid was 80 per cent of the cash flow generated from oper-

ating activities. Dividends deplete the resources the entity can use to invest in operating assets that

can fund future cash flows.

Cash flow ratio

The cash flow ratio compares the cash flow from operating activities with the current liabilities, and is

used to assess liquidity. Liquidity measures the ability of the entity to meet its financial obligations. As

shown in figure 7.5, JB Hi-Fi Ltd had a cash flow ratio in 2015 of 0.47 times or 47 per cent. This means

that the cash flows from operating activities can cover 47 per cent of JB Hi-Fi Ltd’s current obligations.

The higher the ratio, the better the entity’s ability to meet its obligations. The equivalent accrual-based

ratio is the current ratio, measured as current assets over current liabilities. (For JB Hi-Fi Ltd, the current

ratio in 2015 was 1.62 times. In 2014, it was 1.64 times.) The big difference in the cash flow ratio and

the current ratio is due to the accounts receivable and inventory balances.