The importance and limitations of cash flow ratios

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  • Essay Title: A critical review of the importance and limitations of cash flow ratios for the interpretation of financial statements.
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A critical review of the importance and limitations of cash flow ratios for the interpretation of financial statements

2014

ABSTRACT

This study will investigate on the importance and limitations of cash flow ratios for the interpretation of financial statements. It will discuss in detail the reasons which led to the introduction and development of cash flow ratios, the various aspects as to how cash flow ratios are useful and the limitation of cash flow ratios as an indicator of the financial strength of an organisation.

ACKNOWLEDGEMENT

CONTENTS

Chapter- 01

1.1 Introduction To Ratios

Financial ratios can be identified as the main analytical tool used for the evaluation of the financial performance and position of organisations.

Many have defined ratios in many different ways as follows;

ï‚· According to Khan and Jain (2004) ratios are defined as “the numerical or quantitative relationship between two variables”.

ï‚· Leach (2010) describes ratios as “A ratio is simply one number divided by another. In financial terms an accounting ratio is one figure from a set of accounts divided by another figure.”

Thus, it can be concluded that ratios are a quantitative measure of value which show the inter relationship between two different variables.

1.2 Ratio Analysis

The term “ratio analysis” can be explained as “the systematic use of ratio to interpret the financial statements of a firm so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined” (Khan and Jain 2004).

“Ratios, however, will only be meaningful if compared intra-company and inter-company. Intra-company analysis is where ratios are compared within the company, while inter-company analysis is where ratios are compared between or among the same type of companies.”( Ibarra 2009,cited in Weygandt, Kieso, & Kimmel, 1998).This conclusion arrived at by C. Ibarra clearly explains the fact as to how ratios are of immense use in the practical world. Ratios cannot be of any use as a standalone measure; but should be compared with a standard set for example an industry ratio in order to make it a much meaningful measure which can be used by firms to improve their current and future comparative performances.

1.3 Evolution of Ratios

These financial ratios are said to be in use since the nineteenth century. Traditionally, the current ratio and the quick ratio were used to analyse the financial performance and position of the business. The below statements made by various authors show the relative importance of ratios as a technique to assess the financial aspects of a firm.

ï‚· Kamal and Quader (2010),cited in Bliss considers ratios to be “indicators of the status of fundamental relationships within the business”.

ï‚· Weil, Schipper and Francis(2014, p.222), state that ratios aid financial statement analysis because they summarize data in a form easy to understand, interpret and compare.

ï‚· According to Moyer et al. (2012, p.70) financial analysis assists in identifying the major strength and weaknesses of a business enterprise.

Therefore it can clearly be identified that ratios when computed accurately and used appropriately are one of the best ways to access a firm in terms of its liquidity, solvency and future stability.

However, these traditional ratios being exclusively relied upon the values derived from the Income statement and Statement of Financial Position gave rise to the concept of cash flow based ratios. These cash flow indicator ratios are said to provide a better insight of the company than the traditional ratios as they consider the values of real cash that has flown to and from the company than evaluating their performance based on accrual accounting.

1.4 Failure Of Traditional Ratios

It was in 1919, the Du Pont Company introduced its famous ratio analysis- the “du Pont Identity” or “ratio triangle” (Kamal & Quader 2010, p.39). This can be identified as one of the major step which led towards the evolution of financial ratios. Accordingly, the current ratios which are categorized as traditional financial ratios came in to use widely.

Kamal and Quader(2007) quoting from Merwin (1942) and Tamari (1966) state that “current ratios are useful in assessing the financial health of companies and measuring the risk involved within them. Their studies reveal that the current ratios of failed firms were generally less than those of the industry.” This shows that in the early era the computations and comparisons were heavily dependent on the current ratio.

But later with the realization that balance sheet data is constant and the income statement contains many subjective non - cash allocations like depreciation and amortization analysts started to explore on more accurate methods of evaluating businesses. It is clear that the ratios computed using these statements too will be subjected to these pitfalls. This can be supported by the below argument:

The concept of defensive assets (cash and cash equivalents) being critiqued as constant and needing to be replaced by cash flows from trading cash flow ratios were introduced. For instance, Kamal and Quader’s conclusion (2010) supported the views of Bierman(1960) on the quick ratio, current ratio, and the several stock equity ratios all giving static measures and failing to take into account the rate at which funds are being generated.

As a result, in order to overcome the limitations of these traditional ratios the new concept of cash flow ratios was introduced.

1.5 Introduction And Development Of Cash Flow Ratios

In 1987 with the introduction of cash flow statements as an essential component of the annual reports by the Financial Accounting Standards Board (FASB) and due to the limitations of traditional ratios being realized by the early scholars the use of cash flow ratios came in to wide recognition globally.

Chapter- 02

Importance Of Cash flow Ratios

2.1 An overview of its importance

Many arguments have been presented by many implying the varied use of cash flow ratios in comparison to traditional measures. They can be presented as follows;

Jooste(2007) elucidates that the value of cash flow information is that it can be used to assess the quality of earnings, financial flexibility and assists in forecasting cash flows. Cash flow information should also give a better indication of the liquidity of an entity, because nothing is more liquid than cash. If cash flow ratios can be used as a liquidity measure, they can predict financial failure and, ultimately, bankruptcy. Therefore, an early warning of possible financial distress can ultimately help to prevent subsequent financial failure.

Subatnieks (2005) identifies that traditional financial statement liquidity ratios are based upon utilization of two balance sheet ratios; the current ratio and the quick ratio. The cash flow statement can be used to measure company’s liquidity in a different way than normal. To my opinion, this is a more reliable tool than those usually used to measure liquidity.

It can all be summarized in one statement as -"Happiness is a positive cash flow," as said by Ibarra (2009) cited in Kieso, Weygandt, and Warfield (2004).This single phrase stresses the importance of having a positive cash flow which eventually leads to better cash flow ratios.

Therefore as per the above presented ideas of different scholars it’s very clear that cash flow based measures are better performance indicators than other measures.

The uses of cash flow ratios can be summarized as follows;


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