Financial Ratio Tutorial

Expressed as an indicator (days) of management performance efficiency, the operating cycle is a "twin" of the cash conversion cycle. While the parts are the same - receivables, inventory and payables - in the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets, as opposed to their impact on cash. 
 
Formula:

 

Components:

DIO is computed by:

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
2. Calculating the average inventory figure by adding the year's beginning (previous yearend amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of inventory for any given year; and
3. Dividing the average inventory figure by the cost of sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DIO would be computed with these figures:

 
DSO is computed by:

1. Dividing net sales (income statement) by 365 to get net sales per day figure;
2. Calculating the average accounts receivable  figure by adding the year's beginning (previous yearend amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable for any given year; and
3. Dividing the average accounts receivable figure by the net sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DSO would be computed with these figures:

DPO is computed by:

• Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
• Calculating the average accounts payable figure by adding the year's beginning (previous yearend amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and
• Dividing the average accounts payable figure by the cost of sales per day figure.

For Zimmer Holdings' FY 2005 (in $ millions), its DPO would be computed with these figures:

 
Computing OC 
Zimmer Holdings' operating cycle (OC) for FY 2005 would be computed with these numbers (rounded):

 
Variations: 
Often the components of the operating cycle - DIO, DSO and DPO - are expressed in terms of turnover as a times (x) factor. For example, in the case of Zimmer Holdings, its days inventory outstanding of 280 days would be expressed as turning over 1.3x annually (365 days ÷ 280 days = 1.3 times). However, it appears that the use of actually counting days is more literal and easier to understand.  
 
Commentary: 
As we mentioned in its definition, the operating cycle has the same makeup as the cash conversion cycle. Management efficiency is the focus of the operating cycle, while cash flow is the focus of the cash conversion cycle. 
 
To illustrate this difference in perspective, let's use a narrow, simplistic comparison of Zimmer Holdings' operating cycle to that of a competitive peer company, Biomet. Obviously, we would want more background information and a longer review period, but for the sake of this discussion, we'll assume the FY 2005 numbers we have to work with are representative for both companies and their industry.

 
 
 

 
When it comes to collecting on its receivables, it appears from the DSO numbers, that Zimmer Holdings is much more operationally efficient than Biomet. Common sense tells us that the longer a company has money out there on the street (uncollected), the more risk it is taking. Is Biomet remiss in not having tighter control of its collection of receivables? Or could it be trying to pick up market share through easier payment terms to its customers? This would please the sales manager, but the CFO would certainly be happier with a faster collection time. 
 
Zimmer Holdings and Biomet have almost identical days inventory outstanding. For most companies, their DIO periods are, typically, considerably shorter than the almost 10-month periods evidenced here. Our assumption is that this circumstance does not imply poor inventory management but rather reflects product line and industry characteristics. Both companies may be obliged to carry large, high-value inventories in order to satisfy customer requirements. 
 
Biomet has a huge advantage in the DPO category. It is stretching out its payments to suppliers way beyond what Zimmer is able to do. The reasons for this highly beneficial circumstance (being able to use other people's money) would be interesting to know. Questions you should be asking include: Does this indicate that the credit reputation of Biomet is that much better than that of Zimmer? Why doesn't Zimmer enjoy similar terms? 
 
Shorter Is Better? 
In summary, one would assume that "shorter is better" when analyzing a company's cash conversion cycle or its operating cycle. While this is certainly true in the case of the former, it isn't necessarily true for the latter. There are numerous variables attached to the management of receivables, inventory and payables that require a variety of decisions as to what's best for the business.  
 
For example, strict (short) payment terms might restrict sales. Minimal inventory levels might mean that a company cannot fulfill orders on a timely basis, resulting in lost sales. Thus, it would appear that if a company is experiencing solid sales growth and reasonable profits, its operating cycle components should reflect a high degree of historical consistency. 

Cash Flow Indicator Ratios: Introduction

This section of the financial ratio tutorial looks at cash flow indicators, which focus on the cash being generated in terms of how much is being generated and the safety net that it provides to the company. These ratios can give users another look at the financial health and performance of a company.

At this point, we all know that profits are very important for a company. However, through the magic of accounting and non-cash-based transactions, companies that appear very profitable can actually be at a financial risk if they are generating little cash from these profits. For example, if a company makes a ton of sales on credit, they will look profitable but haven't actually received cash for the sales, which can hurt their financial health since they have obligations to pay. 
 
The ratios in this section use cash flow compared to other company metrics to determine how much cash they are generating from their sales, the amount of cash they are generating free and clear, and the amount of cash they have to cover obligations. We will look at the operating cash flow/sales ratio, free cash flow/operating cash flow ratio and cash flow coverage ratios. 
 
 
Cash Flow Indicator Ratios: Operating Cash Flow/Sales Ratio

his ratio, which is expressed as a percentage, compares a company's operating cash flow to its net sales or revenues, which gives investors an idea of the company's ability to turn sales into cash. 
 
It would be worrisome to see a company's sales grow without a parallel growth in operating cash flow. Positive and negative changes in a company's terms of sale and/or the collection experience of its accounts receivable will show up in this indicator. 
 
Formula:

 
Components:

 
 

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net cash provided by operating activities of $878.2 (cash flow statement), and net sales of $3,286.1 (income statement). By dividing, the equation gives us an operating cash flow/sales ratio of 26.7%, or approximately 27 cents of operating cash flow in every sales dollar.  
 
Variations: 
None 
 
Commentary: 
The statement of cash flows has three distinct sections, each of which relates to an aspect of a company's cash flow activities - operations, investing and financing. In this ratio, we use the figure for operating cash flow, which is also variously described in financial reporting as simply "cash flow", "cash flow provided by operations", "cash flow from operating activities" and "net cash provided (used) by operating activities". 
 
In the operating section of the cash flow statement, the net income figure is adjusted for non-cash charges and increases/decreases in the working capital items in a company's current assets and liabilities. This reconciliation results in an operating cash flow figure, the foremost source of a company's cash generation (which is internally generated by its operating activities). 
 
The greater the amount of operating cash flow, the better. There is no standard guideline for the operating cash flow/sales ratio, but obviously, the ability to generate consistent and/or improving percentage comparisons are positive investment qualities. In the case of Zimmer Holdings, the past three years reflect a healthy consistency in this ratio of 26.0%, 28.9% and 26.7% for FY 2003, 2004 and 2005, respectively. 
 

Cash Flow Indicator Ratios: Free Cash Flow/Operating Cash Flow Ratio

The free cash flow/operating cash flow ratio measures the relationship between free cash flow and operating cash flow.  
 
Free cash flow is most often defined as operating cash flow minus capital expenditures, which, in analytical terms, are considered to be an essential outflow of funds to maintain a company's competitiveness and efficiency. 
 
The cash flow remaining after this deduction is considered "free" cash flow, which becomes available to a company to use for expansion, acquisitions, and/or financial stability to weather difficult market conditions. The higher the percentage of free cash flow embedded in a company's operating cash flow, the greater the financial strength of the company.  
 
Formula:

 
Components:

 
 
 
s of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had free cash flow of $622.9. We calculated this figure by classifying "additions to instruments" and "additions to property, plant and equipment (PP&E)" as capital expenditures (numerator). Operating cash flow, or "net cash provided by operating activities" (denominator), is recorded at $878.2. All the numbers used in the formula are in the cash flow statement. By dividing, the equation gives us a free cash flow/operating cash flow ratio of 70.9%, which is a very high, beneficial relationship for the company. 
 
Variations: 
A more stringent, but realistic, alternative calculation of free cash flow would add the payment of cash dividends to the amount for capital expenditures to be deducted from operating cash flow. This added figure would provide a more conservative free cash flow number. Many analysts consider the outlay for a company's cash dividends just as critical as that for capital expenditures. While a company's board of directors can reduce and/or suspend paying a dividend, the investment community would, most likely, severely punish a company's stock price as a result of such an event. 
 
Commentary: 
Numerous studies have confirmed that institutional investment firms rank free cash flow ahead of earnings as the single most important financial metric used to measure the investment quality of a company. In simple terms, the larger the number the better.

Cash Flow Indicator Ratios: Cash Flow Coverage Ratios

This ratio measures the ability of the company's operating cash flow to meet its obligations - including its liabilities or ongoing concern costs.  
 
The operating cash flow is simply the amount of cash generated by the company from its main operations, which are used to keep the business funded. 
 
The larger the operating cash flow coverage for these items, the greater the company's ability to meet its obligations, along with giving the company more cash flow to expand its business, withstand hard times, and not be burdened by debt servicing and the restrictions typically included in credit agreements. 
 
Formulas: 

 
 
 

 
Components:

 
 

 

 

 
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had no short-term debt and did not pay any cash dividends. The only cash outlay the company had to cover was for capital expenditures, which amounted to $255.3 (all numbers for the cash flow coverage ratios are found in the cash flow statement), which is the denominator. Operating cash is always the numerator. By dividing, the operative equations give us a coverage of 3.4. Obviously, Zimmer is a cash cow. It has ample free cash flow which, if the FY 2003-2005 period is indicative, has steadily built up the cash it carries in its balance sheet.  
 
Variations: 
None 
 
Commentary: 
The short-term debt coverage ratio compares the sum of a company's short-term borrowings and the current portion of its long-term debt to operating cash flow. Zimmer Holdings has the good fortune of having none of the former and only a nominal amount of the latter in its FY 2005 balance sheet. So, in this instance, the ratio is not meaningful in the conventional sense but clearly indicates that the company need not worry about short-term debt servicing in 2006. 
 
The capital expenditure coverage ratio compares a company's outlays for its property, plant and equipment (PP&E) to operating cash flow. In the case of Zimmer Holdings, as mentioned above, it has ample margin to fund the acquisition of needed capital assets. For most analysts and investors, a positive difference between operating cash flow and capital expenditures defines free cash flow. Therefore, the larger this ratio is, the more cash assets a company has to work with.  
 
The dividend coverage ratio provides dividend investors with a narrow look at the safety of the company's dividend payment. Zimmer is not paying a dividend, although with its cash buildup and cash generation capacity, it certainly looks like it could easily become a dividend payer.  
 
For conservative investors focused on cash flow coverage, comparing the sum of a company's capital expenditures and cash dividends to its operating cash flow is a stringent measurement that puts cash flow to the ultimate test. If a company is able to cover both of these outlays of funds from internal sources and still have cash left over, it is producing what might be called "free cash flow on steroids". This circumstance is a highly favorable investment quality.