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Cash-Flow From Operations Ratio

This ratio measures liquidity of a firm by comparing actual Cash flows from operations (in lieu of current and potential cash inflows from CAs such as inventory and debtors) with current liability. It Is calculated as per Equation 7.7

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Being a cash measure. the ratio does not encounter the problems of actual convertibility of current and debtors and inventory and the need for maintaining minimum levels of these assets. In general, the higher the ratio, the bear is a firm from the point of view of liquidity.

To conclusion the discussion of liquidity ratios, the short-term of a firm can be judged not merely terms of the  liquidity ratios such as current and acid-test, but the analysis should also be extended towards examining the quality of turnover of the items of current assets on which such ratios are based. The qualitative considerations (turnover ratios) coupled with the defensive-interval cash flow from operation ratios would reveal the true liquidity position of the firm.

The liquidity ratios are no doubt, primarily relevant from the viewpoint of the creditors of the firm. In theory, therefore, the higher. The liquidity ratios, the better is the firm. But high ratios have serious implications from the firm’s point of view. High current and acid-test ratios would imply that funds have unnecessarily accumulated, and are nut being profitably utilized. Similarly an ,unusually high rate of inventory turnover may indicate that a firm is losing business by maintain an adequate level of inventory to serve the customer’s needs. A rapid turnover of debtors may reflect strict credit policies revenue below levels that could be obtained by granting more liberal credit terms.

Finally, while interpreting the short-term position of the firm by the creditors, it should be recognized that the management may be tempted to indulge in window-dressing just before the financial statements are prepared so as to make the current financial position appear better than what it actually is, For instance, by postponing purchases, allowing inventories to fall below the normal levels, using all available cash to payoffs current liabilities and pressing collection on debtors, the current and acid-test ratios, and debtors turnover ratios may be artificially improved. Even when no deliberate attempt has been made to present a good picture, the current financial position shown by the year-end financial statements is probably more favorable than at any other time of the year, This is particularly true when a firm adopts a natural business year that ends during an ebb in the seasonal swing of business activity. At the time of peak activity, debtors, inventories and current liabilities lend 10 be at higher levels. In such cases, an analysis of current financial position based solely on year-end data will tend to over-state a firm’s average liquidity position.

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