Analysing cash flow statements - Part 2

In Part 1 we looked at the cash flow statement and pointed out a couple of 'red flags'. This issue we're going to learn how to calculate and apply a few useful cash flow ratios.

The first, which you sometimes see in broker reports – don't let that put you off - is the depreciation/capex ratio. It's an ugly piece of jargon but it serves a very useful purpose.

Depreciation is an expense you'll find in the income statement (the old statement of financial performance), an accounting charge designed to recognise the fact that most assets wear out over time.

In Security Analysis (the 1934 edition) Benjamin Graham hit the nail on the head when he stated that 'in the majority of cases the depreciation charges are consumed or offset over a period of time by even larger cash expenditures made for replacements or extensions.'

Capex ratio

As any long-term car owner knows, it costs more to replace a 'depreciated' old vehicle with a modern equivalent.

This is a critical point – most companies' accounting depreciation charges don't represent the actual cost of replacement in today's dollars. And here's where the depreciation/capex ratio can come in handy.

Capex is short for capital expenditure. This is the amount a company spends on new property, plant and equipment. You'll find it in the 'cash flows from investing activities' section of the cash flow statement.

In the case of David Jones the figure was $97.7m for the 2001 year. However, the next line showed the company collected 204,024 from the sale of property, plant and equipment.

Some analysts just use the first figure but we like to subtract the second figure (what the company received from the sale of 'old assets') from it to give a more accurate reading on net capex.

In this example, capex for the year was positive, which is unusual. It's also a great example of why crunching numbers in a vacuum is useless – you must understand what is happening in the underlying business first.

As we said in issue 89/Oct 01 (Better Value Elsewhere - $1.16) David Jones has been doing some financial 're-engineering', involving, among other things, selling property assets and then leasing them back. Had DJs been undergoing a major refurbishment the spending on property, plant and equipment will appear higher than the 'underlying' level.

Discrepancies

So how does one overcome these discrepancies? By analysing this ratio over a period of several years, not just one. This way, you'll be able to see the difference between the actual cash capex figure and the accounting depreciation.

If this ratio is less than one over a long period, it means the company is constantly spending a lot more than it is depreciating for accounting purposes. Miller's Retail and Cochlear are good examples.

It's normal for growing companies such as these but can place a strain on their cash flow. If the ratio is over one, as it is for Transurban and Sydney Aquarium, then the accounting profit will understate the actual earnings (note: the examples use figures from 2001 and earlier).

More on cash flow ratios

Another useful cash flow ratio is the cash flow from operations to net debt ratio.

Using DJs 2001 numbers once again, take the cash flow from operations figure of $52.2m and compare it to the net debt figure of $50.2m. This gives a ratio of 1.04, which is very low.

In plain English, this ratio tells you how many years of cash flow it would take the company to pay off its debts, if it had to. It's a good measure of a company's financial health.

To calculate the price-to-cash flow ratio take the current price per share and multiply it by the number of shares on issue. This will give you the 'price' of the whole business (that is, its market capitalisation). Then divide this figure by the cash flow from operations.

Let's say the price of a DJs share is $1.20 and there are 393.7m shares on issue. That gives a price of $472.4m compared to the cash flow from operations of $52.2m.

That's a price-to-cash flow ratio of 9.5. However, this is not directly comparable to a price-to-earnings ratio (PER) because it doesn't take depreciation (or capital expenditure) into account.

Before we call it quits, remember our warning from Part 1 to be careful when using the cash flow from operations figure. It may or may not contain the interest that the company has paid and received.