7 Cash Flow Ratios Every Value Investor Should Know


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We’ve got balance sheet ratios covered.

If you have seen some of the ratios that we cover in our stock analysis software, you will see something like this:

stock analysis software ratios

Balance sheet and income related ratios are one of the first sets of financial ratios you learn to use when analyzing a company.

  • Current and Quick Ratio
  • Debt to Equity
  • Return on Equity
  • and so on

Very popular and common.

Before you dive into the meat of the content, if you haven’t signed up with your email for our free investment resources, do so.

I’ll immediately send you extra stock ratios notes, checklists, spreadsheets and additional downloads you can succeed with.

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What the Balance Sheet and Income Statement Ratios Miss

When it comes to doing a liquidity or solvency analysis, using the cash flow statement is a better indicator than using the balance sheet or income statement.

Gross margins are important, but it doesn’t tell you whether a company will survive or not.

The PE doesn’t help.

Unfortunately, the cash flow statement analysis and good ol’ cash flow ratios analysis is usually pushed down to the bottom of the to do list.

The income statement has a lot of non cash numbers like depreciation and amortization which does not affect cash flow. On paper, and at the top of the financial statement, it may look like a company is making or losing money when you account for depreciation and amortization, the actual cash in and outflow could show a different picture.

What you want to do is differentiate between accrual accounting methods and the flow of cash.

Balance sheet ratios also have their limitations as it drills into the financial health of a company at a single point in time.

It gets hard when you try to calculate a consistent going concern analysis.

There are far too many cases where the balance sheet looked healthy one quarter, but then investors are met with a huge surprise as debt balloons, cash dives and the company falls into dangerous territory.

But the cash flow statement works to untangle bookkeeping numbers and the changes from the other two statements to give a number that you really care about.

Cash is King

cash is king

As much as Wall Street loves earnings, the core engine behind a business and earnings is cash.

Cash creates earnings.

Earnings does not create cash.

Some people think this is like the chicken and the egg question, but it’s simple.

If a business does not have cash and can’t maintain liquidity, there will be no earnings.

Earnings was born from cash. Not the other way around.

Let’s dig into some of those juicy cash flow ratios.

The purpose of these cash flow ratios is to provide as much information and detail as possible to cover all bases. That way, you can try it out yourself and pick the ones that work for you.

When using ratios, it’s important to compare ratios between competitors.

Numbers across industries and sectors will vary, so make sure you are comparing apples to apples.

Operating Cash Flow Ratio

Cash Flow from Operations (CFO) /Sales

Using FCF instead of Operating Cash Flow is a variation you can apply to most of the cash flow statement ratios.

For this cash flow ratio, it shows you how many dollars of cash you get for every dollar of sales.

Unlike most balance sheet ratios where there is a certain threshold you want to look for (BV < 1 for cheapness, debt to equity ratio < 1 etc), there is no exact percentage.

The higher the percentage, the better as it shows how profitable the company is.

Tip: Make sure that the operating cash flow increases in line with sales over time. You don’t want to see it deviate from each other too much as it’s a sign of weakness and inconsistency.

Alternatives: FCF/Sales

Asset Efficiency Ratio

CFO / Total Assets

Similar to ROA, but uses cash flow from operations instead of net income.

This is a basic ratio to show you how well the company uses its assets to generate cash flow.

It’s best used to view the historical trend as well as to compare with competitors.

Tip: Instead of Total Assets, the ratio can be cleaned up by using just PP&E.

Alternatives: CFO / PP&E

Current Liability Coverage Ratio

To test for solvency, this is a simple ratio.

CFO / Current Liabilities

or

(CFO – Dividends Paid) / Current Liabilities

The more accurate method is to subtract the cash used to pay off dividends as it will give a truer picture of the operating cash flows.

This ratio gives you an idea about the company’s debt management practices.

E.g. a value of 4.3 means that the current cash flows can pay for 4.3x the current liabilities.

The higher the number the better.

If it drops below 1, then CFO is unable to pay the current liabilities.

It’s also a better indicator of the company’s ability to pay current liabilities than the current ratio or quick ratio.

Tip: This ratio is used to analyze the short term stability of a company. This ratio also includes the current maturing portion of long term debt.

Alternatives:

  • CFO/Short Term Debt
  • FCF/Current Liabilities
  • FCF/Short Term Debt

Long Term Debt Coverage Ratio

CFO / Long Term Debt

or

(CFO – Dividends Paid) / Long Term Debt

If you have a ratio for short term liabilities, then it makes sense to have one for long term debt.

A common error is bunching up all forms of debt without splitting it up.

That’s why if you just use the Debt/Equity ratio only, you should start looking at Short Term Debt/Equity and Long Term Debt/Equity.

But again, using cash flow numbers gives you an immediate sense of whether the company can pay off the debt.

The higher the number, the more cash from operations is required to pay off debt.

If the ratio is trending down, management may raise more capital via dilution, or additional debt.

Alternatives:

  • FCF/Long Term Debt

Interest Coverage Ratio

(CFO + Interest Paid + Taxes Paid) / Interest Paid

The multiple you get from this ratio will show you the company’s ability to make the interest payments on its entire debt load.

A highly leveraged company will have a low multiple.

A company with a strong balance sheet will have a high multiple.

If the interest coverage is less than 1, the company has a high risk of default.

Alternatives:

By substituting CFO for FCF in this equation, it tells you whether the company is able to pay off the interest from it’s FCF. FCF has to be positive for this to work of course.

  • (FCF + Interest Paid + Taxes Paid) / Interest Paid

Cash Generating Power Ratio

CFO / (CFO + Cash from Investing Inflows + Cash from Financing Inflows)

I love the name of this one.

The Cash Generating Power Ratio is designed to show the company’s ability to generate cash purely from operations, compared to the total cash inflow.

Instead of using the entire cash from investing activities and cash from financing activities, only the inflows is used.

E.g. Here’s a snapshot of AMD’s cash flow statement.

The red rows are the numbers that are used for this ratio.

Cash Generating Power Ratio Components

Cash Generating Power Ratio Components | Enlarge

Try it with one of your holdings, but here’s what I see with Advanced Micro Devices (AMD).

  • 2012: -22.4%
  • 2013: -9.9%
  • 2014: -5.2%
  • 2015: -90.7%
  • 2016: 4.7%

The numbers have been improving, but when you do this exercise, you will see that a lot of the cash being generated is a result of selling stocks.

It shows that AMD can’t generate enough cash from operations alone. They need to dip into trading securities and issuing debt to survive.

Now take a look at Intel (INTC)

  • 2012: 55.4%
  • 2013: 71.5%
  • 2014: 64.3%
  • 2015: 45.0%
  • 2016: 61.6%

Intel also has a large chunk of proceeds from marketable securities sales, but the biggest difference is their positive cash from operations.

I know which company I’d prefer to buy.

External Financing Index Ratio

Cash from Financing / CFO

This ratio compares the cash flow from financing activities with cash from operation to show how dependent the company is on financing.

The higher the number, the more dependent the business is on external money.

The strongest companies like MSFT and INTC have negative ratios because they are able to pay back stock or debt so the net cash from financing is negative.

On the other hand, AMD is also negative, but for the wrong reasons.

Until last year, Cash from Financing was positive and cash from operations was negative – a red flag.

Cash Flow Ratios Summary

Cash Flow Ratios

Cash Flow Ratios | Enlarge

More Financial Stock Ratios?

Follow the links below to get more educational content on financial ratios and analysis. Being able to combine qualitative research with quantitative research is a powerful 1-2 combo.

What you don’t want to do is skim through it, hoard all the resources I share with you and never use it.

Instead, pick 2 or 3 ratios that matches your investment style and apply it on 5 of your stocks.

Still too much work?

You can automate it by using the Old School Value stock analyzer spreadsheet – spreadsheet for members is unlocked so you can add your own custom ratios or edit existing ones.

OSV Online does not have all the ratios on this page, but it’s filled with plenty of other financial analysis and Buffett style ratios which you can see for yourself in the live preview.

You can get full access to AMZN, AAPL, MSFT, BAC and RHI from the preview.

Additional Learning Links

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