An evaluation of the usefulness of the cash flow statement within South African companies by means of cash flow ratios

Abstract

With the introduction of SFAS 95 in 1987, the cash flow statement became an integral part of financial reporting. With this a need arose for the development of ratios for the effective evaluation of the cash flow statement. The primary objective of this study was to determine the usefulness of the cash flow statement by means of cash flow ratios. Beaver (1966) was the first researcher to stress the importance of cash flow information for predicting financial failure and, therefore, the study investigated the available cash flow ratios of various authors. Eight cash flow ratios were suggested for inclusion in a financial analysis. Failed entities were selected and evaluated by means the selected cash flow ratios for five years prior to their failure. Non-failed entities were selected and included in the evaluation. The results of the ratios were used to calculate mean values for each ratio and year prior to failure. The ratios of the failed entities were compared with those of the non-failed entities. A comparison of the ratios revealed that the cash flow ratios have predictive value. The cash flow to total debt and ratio was identified as the ratio with the greatest potential to predict financial failure. The mean value of the ratio was weaker than the mean of the non-failed entities in four out of five years. The mean values of the cash flow ratios of the failed entities performed weaker overall than the non-failed entities. Failed entities not only have lower cash flows than non-failed entities but they also have smaller reserves of liquid assets. Therefore, they have less capacity to meet obligations and they tend to incur more debt. The ratios of the failed entities were also unstable. The study concluded that cash flow ratios calculated from the cash flow statement enhanced the usefulness of financial statements. A need, however, remains for consensus on a comprehensive set of cash flow ratios for financial analysis. If cash flow ratios are used in conjunction with traditional ratios it should lead to a better understanding of the financial strengths and weaknesses of an entity.