Cash is one of the important levers of the financial performance of a firm for its equity shareholders, debt investors and other stakeholders. Let us discuss how one can evaluate the cash flow management efficiency of a firm.

Let us look at the financials of Priyanka Vaishnavi Ltd (PV) for its latest financial year: Cash from operations (CFO) Rs 12,500 crore; capital expenditure Rs 5,000 crore; current liabilities Rs 6,500 crore. It does not have interest-bearing short-term debt and the long-term debt outstanding is Rs 8,000 crore and net income is Rs 6,250 crore.

Types of cash flow
Cash flows are classified into three variants; namely, operating cash flow (cash flow from operating activities or CFO), cash flow from investing activities and cash flow from financing activities. Among these, CFO is critical in meeting the cash outflows in the day-to-day activities of a firm. A firm should have a positive figure for CFO to get the attention of the investors (both debt and equity). Piotroski’s F score framework offers a positive rating for a firm with a positive figure in its CFO.

Cash Flow Management Ratios: The following four ratios could be used by the young investors in evaluating the cash flow management of their target firms.

CFO to Net Income
This ratio is otherwise known as quality of earnings ratio. It is computed by dividing CFO by Profit After Tax (PAT or Net Income) of a firm. If CFO exceeds the net income, then it is considered the firm can convert its accounting (accrual) earnings into cash. Else, the firm has poor cash flow management practices. For PV, it is two times (= CFO of Rs 12,500 crore / PAT of Rs 6,250 crore), which indicates that the firm is good in managing its cash flows.

CFO to Capex
Capex refers to capital expenditure. This ratio is computed by dividing CFO by the capex of a firm. It reveals the ability of the firm in funding its capex using its cash generated from operating activities. For PV, it is 2.5 times (CFO of Rs 12,500 crore / capex of Rs 5,000 crore). The firm is good on this metric as it has Rs 2.5 for every Rs 1 in capex.

CFO to total debt
It is computed by dividing CFO by the total debt (Sum of interest bearing current and long-term debt). The ratio should be at least one for a healthy firm. For PV, total debt is Rs 8,000 crore. The CFO to total debt for PV, it is 1.56 times (CFO of Rs 12,500 crore / total debt of Rs 8,000 crore). This reflects that PV is attractive for its lenders as it has CFO at 1.5 times of its total debt.

CFO to current liabilities
It is calculated by dividing CFO by the current liabilities of a firm. Higher the CFO in relation to the current liabilities, better is the ability of a firm in repaying its current liabilities. For PV, it is 1.92 times (i.e., Rs 12,500 crore/Rs 6,500 crore) which reveals that the firm is reasonably efficient in honoring the payment of its current liabilities.

If we assign a score of one on every parameter, then PV gets four out of four for its cash flow management.

Source : PTI