Cash Flow on Total Assets Equation

Cash flow information has limitations, but it can help measure a company’s ability to meet its obligations, pay dividends, expand operations, and obtain financing. Users often compute and analyze a cash-based ratio similar to return on total assets except that its numerator is net cash flows from operating activities. The cash flow on total assets Ratio of operating cash flows to average total assets; not sensitive to income recognition and measurement; partly reflects earnings quality. ratio is in Exhibit 16.14.

EXHIBIT 16.14 Cash Flow on Total Assets

This ratio reflects actual cash flows and is not affected by accounting income recognition and measurement. It can help business decision makers estimate the amount and timing of cash flows when planning and analyzing operating activities.
To illustrate, the 2009 cash flow on total assets ratio for Nike is 13.5%—see Exhibit 16.15. Is a 13.5% ratio good or bad? To answer this question, we compare this ratio with the ratios of prior years (we could also compare its ratio with those of its competitors and the market). Nike’s cash flow on total assets ratio for several prior years is in the second column of Exhibit 16.15. Results show that its 13.5% return is the lowest return over the past several years. This is probably reflective of the recent recessionary period.

EXHIBIT 16.15 Nike’s Cash Flow on Total Assets

As an indicator of earnings quality, some analysts compare the cash flow on total assets ratio to the return on total assets ratio. Nike’s return on total assets is provided in the third column of Exhibit 16.15. Nike’s cash flow on total assets ratio exceeds its return on total assets in each of the five years, leading some analysts to infer that Nike’s earnings quality is high for that period because more earnings are realized in the form of cash.

Decision Insight Cash Flow Ratios  Analysts use various other cash-based ratios, including the following two: (1)         where a low ratio (less than 1) implies cash inadequacy to meet asset growth, whereas a high ratio implies cash adequacy for asset growth. (2)        When this ratio substantially and consistently differs from the operating income to net sales ratio, the risk of accounting improprieties increases.

Point: The following ratio helps assess whether operating cash flow is adequate to meet long-term obligations:

Cash coverage of debt = Cash flow from operations ÷ Noncurrent liabilities.

A low ratio suggests a higher risk of insolvency; a high ratio suggests a greater ability to meet long-term obligations.