5.11 Cash Flow Ratio 

One of the main ideas behind the price to cash flow ratios is the assumption that cash flows are less open to manipulation than are accrual based income measures.  This is similar to what we said about Price to Sales Ratios.  However, just as sales can be manipulated, so too can cash flows and related concepts like free cash flows.  Therefore, the discussion of critical accounting policies in the 10-K is important even when working with price to cash flow ratios. 

As a check against accounting manipulations, analysts often contrast price earnings ratios with a series of price to cash flow ratios which selectively eliminate different types of accounting accruals.  The common price to cash flow ratios gives you insight into how the market is pricing both working capital management and the firm’s current investment decision.  

Price/Cash Flows from Operations per share

Price/Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) per share

Price/Free Cash Flow per share

The first cash flow measure comes from the Accounting Cash Flow Statement (Indirect Method).  The indirect cash flow statement is required because it links the cash flow statement to the balance sheet and income statement.  Cash flow from operations is the cash the company generates from sales revenue excluding costs associated with long term investments and non-current assets.  It is measured by starting with Net Income and then adjusting for Depreciation, Amortization, Deferred Taxes, Changes in Working Capital and items related to Comprehensive Income that have cash implications but not accounting income implications.  Further adjustments are made for any discontinued operations.

EBITDA is similar to Cash Flows from Operations apart from adjusting for changes in working capital.  As a result, the difference between these two measures simply reflects how the firm currently chooses to finance their net working capital.  For example, it could be a source of funds, which may imply that the firm is managing short term working capital to generate cash.  This could range from delaying paying their creditors, collecting their accounts receivable more quickly, or turning over inventory more efficiently.   The reverse of these types of scenarios would in turn imply that the short run change in working capital uses cash.

Finally, free cash flow is defined as cash flow from operations minus capital expenditure (expenditure on productive capacity which usually involves non-current assets).  Again the difference between Cash Flows from Operations and Free Cash Flow arises from the firm’s investment decision.

Summary of Interpreting across the Price to Cash Flow Ratios

The base measure uses Price/Cash Flows from Operations.  Then Price/EBITDA when contrasted with the base price measure provides insight into how the market is pricing the firm’s working capital management.  Similarly, the Price/FCF ratio when contrasted to the Price /Cash Flow from Operations measure provides insights into how the market is pricing the firm’s investment decision as reflected by Capital Expenditure.