How to Calculate the Solvency, Liquidity, and Viability of your Firm

Important Ratios for Cash Flow Analysis

The cash flow statement is one of the three financial statements a business owner uses in cash flow analysis. Businesses rely on the statement of cash flows to determine their financial strength. Cash flow is the driving force behind the operations of a business.

A cash flow analysis uses ratios that focus on the company's cash flow. It consists most commonly of the price to cash flow ratio, cash flow coverage ratio, and cash flow margin ratio.

Current Liability Coverage Ratio

Sometimes called the current cash debt ratio, this is a measurement of cash from operating activities to average current liabilities. This ratio demonstrates the ability for operations to generate cash that can be used to cover debts that need to be paid within a years' time. 

The ratio is calculated as follows:

Net Cash from Operating Activities ÷ Average Current Liabilities

Price to Cash Flow Ratio

The price to cash flow ratio is an appraisal of a company's share price to its cash flow. This ratio is generally accepted as being more reliable than the price per earnings ratio, as it is harder for false internal adjustments to be made.

To calculate the price to cash flow ratio, use this formula:

Share Price ÷ Operating Cash Flow per Share

The share price is usually the closing price of the stock on a particular day and operating cash flow is taken from the statement of cash flows.

Cash Flow Margin Ratio

The cash flow margin ratio is a key ratio for business owners and managers as it expresses the relationship between cash generated from operations and sales. 

This ratio is specific in that it indicates the amount of cash generated per dollar of net sales.

The formula is:

Cash Flow from Operating Cash Flows ÷ Net Sales

Cash flow from operating cash comes from the firm's statement of cash flows. Net sales are taken from the income statement. The larger the percentage, the better the firm is at converting sales to cash flow.

Cash Flow Coverage Ratio

The cash flow coverage ratio measures the solvency of a company. This is the ability to pay long-term debts.

This ratio is calculated as follows:

Cash Flow from Operations ÷ Total Debt

Cash flow from operations is taken from the statement of cash flows. Total debt is total liabilities, both short and long term. This ratio demonstrates the ability of the company to use its operating cash flows to pay off its debt.

A higher ratio reflects the firm's financial flexibility, and its ability to pay its debts. A ratio of more than 1 is desired. For example, if the cash flow coverage ratio were 1.5, the company could pay it’s debts 1.5 times with operating cash flows. The higher this ratio, the more cash you have leftover from operations after paying debts.

Viability

The four ratios discussed are methods behind determining a firm's financial viability. Viability is the ability for a firm to continue generating income to meet all of its financial obligations while allowing for growth at the same time. Combined, these ratios communicate the effectiveness of a business' operations and demonstrate solvency (paying off long-term debts) and liquidity (paying off short-term debts).