I am confused about why the accruals CF ratio is: NI - CFO - CFI
scaling is OK, understood.
From Level I I recall that CFO is actually derived from NI.
CFO = NI + NonCashCarges - WorkingCapitalInvestments
CFO = NI + NCC - WCI
CFO = NI + NCC -WCI
Plugin for CF Ratio numerator:
NI - (NI + NCC - WCI) - CFI
NI - NI - NCC + WCI - CFI
WCI - NCC - CFI
Working Capital - Noncash Charges - Cash from Investing
Odd, why would we take working capital investment and subtract two items that aren’t even a part of working capital investment when we want to see the change in accrual
This just seems wrong to me. Is my understanding of CFO incorrect? I know the formulas are hoping to capture the increase in accrual assets, its straight-forward in the balance sheet approach, but here it makes no sense from what I know about CFO.
Any insight greatly appreciated!
We are looking for earnings quality, we’re not really interested in the calculation of “Cash Flow” To help you keep this concept straight you should keep this question in mind…
Would I want a company with 100 NI all paid in cash or would I want a company with 100 NI 90% in A/R and 10% in cash. Since, cash is king I want the first case becasue I get my money now and dont have to rely on the firms A/R collection abilities.
So, WC and the changes to WC are captured in CFO such as increases in A/R (decrease CFO), Inventory (decreases CFO), A/P (Increases CFO) etc…
So NI less a higher CFO(pure cash basis element of the FinStmts) is a good thing, you want as low a CF Accrual Ratio as possible.
We also Subtract CFI from NI too, because it is purely cash based and contains no accruals.( +/- Signs matter for CFI depending on where the firm sits in the cycle)
What we end up with is a NI that is stripped of all cash basis and contains only accruals (which are usually bad).
So a NI- CFO-CFI trending higher is bad thign and NI-CFO-CFI trending downward is typically a good thisng and shows strong earnings quality
I’ve stumbled upon this ratio yesterday night and lost couple of hours before I could clarify it in my head.
Basically, NI can be a result of two sources of accruals: one coming out of revenues and expenses (hence CFO) and one coming out of depreciation (hence CFI).
If you have a pure cash based business and zero investment/depreciation NI-CFO-CFI will be zero as all revenues and opex have gone through the CF statement through CFO and therefore NI=CFO (whereas accruals in revenues/opex are things like AR, AP, inventory plus NCCs like provisions).
NI-CFO-CFI=0 can be extended to an example where, alongside the earlier assumption of a pure cash based business for revenues and opex, depreciation from IS equals CFI. Therefore NI-CFO=depreciation and, considering CFI=depreciation, NI-CFO-CFI=0 still holds.
In short, the higher the amount of accruals or NCCs in your IS, the higher the residual value of NI-CFO-CFI as CFO-CFI differs more and more from NI result. (CFO is smaller and smaller due to higher AR, AP or inventory which traps cash and CFI will most probably be bigger or smaller from depreciation).
Sidenote: CFF is not included in the calculation as it primarily includes cash flows which refer to borrowing and repaying of principal - which, in turn, does not go through IS and therefore does not effect NI. That is why the denominator of accruals ratio NOA only includes non-monetary items.
I’ve made a simple calculation in excel that can help better understand this ratio, so if anybody gets frustrated like me give me a pm and i’ll send it to you.
P.S. This is my first post on the forum so I’ve tried to attach the .xlsx with this comment but I don’t see it being a possibility.