The article deals with the methodology of estimating cash flows depending on the enterprise’s life cycle stage. It was suggested to use various indicators of cash flows depending on the life cycle of the company. The tools of cash flow estimation have been improved in order to meet the needs of parties interested in the results of the analysis.
Key words: cash flows, estimation, quadrant of interests.
Essence of the problem
The problem of assessing the effectiveness of cash flows is not sufficiently highlighted in the domestic scientific literature. In particular, for Blank I. [9, p.194-214], the methods of estimating cash flows are based on determining their future value; Kostenko T. [8, p.365-367] limits the estimation of cash flows to defining the liquidity coefficient, which is determined by the ratio of the incoming cash flows to the outcoming ones; Kryukova I.  paid more attention to the estimation of cash flows, in particular, she outlined four coefficients of cash flow efficiency, which included the ratios of efficiency, reinvestment and debt servicing as well as the financial cycle duration.
The main tasks of developing an effective cash flow estimation system is the elaboration of such a method for estimating cash flows, which will be built in accordance with the interests of all parties involved in generating cash flows. In particular, it is proposed to consider the financial ratios of liquidity, profitability and investment efficiency in terms of the quadrant of cash flows interests. A concept of quadrant of cash flows interests represents a new approach in the estimation of cash flows and is introduced for the first time in the article.
The purpose of this method is to obtain the analysis results that will be important at different stages of the enterprise’s life cycle. Such an analysis is of practical importance for various types of cash flow measurement. For instance, it may be used to monitor cash flows in order to improve financial management, to generate cash flow statement for depositors, to generate cash flow efficiency reports for lessors and investors who invest funds in the renovation of the fixed assets for the purpose of obtaining economic benefits in the future.
Presentation of the main research
The main task of estimating cash flows is to determine their effectiveness. For many years, companies used traditional financial statements like the balance sheet and the statement of financial results to analyze the activity effectiveness. With these two reports, companies examine their current condition by simply comparing actual results with the past, planned or average industry indicators. Based on the obtained results, businesses make changes to their activity in order to get the better performance in the future. The generalized indicators of the first level include the profitability indicators, which are determined as the ratio of profit to certain types of assets. Indicators of the second level comprise the indicators that are also defined as the ratio of the cost of a certain group of resources to the main indicator of economic efficiency, i.e. profit .
If necessary, virtually all the coefficients used in the financial analysis can be estimated by the indicators of cash flows. Spheres of application of cash flow coefficients are expanding rapidly with their active development depending on the types of activity and sphere of interests. However, such development occurs only in companies that have access to the financial markets in the developed countries . In Ukraine, such analysis has stuck in its initial phase. The demand for it is believed to grow along with an increase in the volume of investments in the economy and the emergence of modern enterprises with the advanced methods of financial management.
Before evaluating the efficiency of a company’s cash flows, it is necessary to determine the purpose for which it is to be done. Several options for the evaluation purpose and stakeholders in the evaluation process can be distinguished:
- Managers responsible for the operational efficiency.
- Business owners responsible for the effectiveness of all types of activities.
- Contributors who invest in the company and are interested in ensuring the company to bring profits and develop in the future.
- Owners of venture capital or lenders interested in obtaining a percentage from the activity or possibility of long-term repayment of loans.
Depending on the interests of the analyst and the purpose of the analysis, different types of cash flows determining their effectiveness are distinguished. These cash flows form the quadrant of interests as shown below .
Net cash flow from operating activity reflects the efficiency of the main activity. Managers responsible for the effectiveness of the enterprise are usually interested in this indicator.
Net cash flow reflects the effectiveness of the business as a whole. Indicator is required by business owners who should receive information about the availability of free funds.
Free cash flow reflects the cash flow efficiency for a depositor who is interested in further business development (improvement of fixed assets).
Net free cash flow reflects the cash flow efficiency for a creditor who is interested in ensuring that the company can generate sufficient funds to pay dividends and debts.
Figure 1 – Quadrant of interests in cash flow
Quadrant of interests in cash flow reflects the value of the indicator at different levels of the enterprise’s development and management. Different needs for determining the cash flow appear at different life cycle stages.
Starting a business, it is very important for a manager to begin generating operational cash flows that should cover all mandatory payments to support the viability of the web project. Net operating cash flow is the main indicator for the research. This cash flow is formed mainly by means of significant investments, so it is inappropriate to assess their impact at the initial stage of the enterprise’s growth.
With the growth of the activity volume (typically, this is a period from 1 to 2 years), it is very important for the company’s owner to observe the return on investments. Therefore, it is necessary to consider the investment cash flows while determining the effectiveness of the enterprise. That’s why the net cash flow of the enterprise is the main research indicator.
When the company finds itself on the peak of its popularity, the investors begin to get interested in it, longing for investing in long-term guarantees of obtaining interest from business operations. The investor is ready to invest only when the company is able to generate the free cash flow, that is, to receive sufficient funds from operating activities, simultaneously providing the development of the website at their expense.
When an enterprise is in need of development and its own financial resources are lacking, it’s high time to attract funds from the external sources. For a borrower, it is very important not only to receive money for business development, but also to pay off indebtedness on long-term loans and pay investors’ interest. Only paying the investors’ interest, the company will be able to continue its development to the full extent, since the business will enjoy the support of capital. At this development stage, the indicator of net free cash flow is very important. It represents the free cash flow reduced by current liabilities on long-term debts and interest payments to investors.
Consequently, having four main indicators that reflect the efficiency of cash flow at different stages of the enterprise’s development, it is possible to create the cash flow assessment toolkit. The evaluation system is based on a comparison of the main indicators of cash flow efficiency with the following items:
- These indicators form a group of debt coverage ratios and reflect the level of the enterprise’s solvency;
- These indicators form a group of profitability ratios;
- These indicators form a group of the investors’ interest coverage ratios.
Ratios of covering the liabilities of the company solve the main problem of cash flows, i.e. the synchronization of the formation and spending of funds and the ability of the company to pay off debts at certain periods of time. The concept of liquidity is determined by the extent to which the obligations of various maturity are covered by cash.
Taking into account different purposes of the analysts, indicators should be investigated in the context of the quadrant of interests in cash flows.
1.1. Urgent Liabilities Liquidity Ratio (ULLR). Traditionally, it is calculated as the ratio of net operating cash flow (CFO) to the amount of urgent liabilities (UL):
ULLR = CFO / (UL-CB)
This indicator can also be investigated as a ratio of net cash flow to the urgent liabilities. In such case, the importance of coverage for all business activities will be explored. The indicator is called the Urgent Liabilities Cash Flow Liquidity Ratio (ULCF). Coverage of liabilities can also be considered by means of free cash flow (ULFCF) and net free cash flow (ULNFCF).
ULcf = CF / (UL-CB)
ULfcf = FCF / (UL-CB)
ULnfcf = NFCF / (UL-CB)
1.2. Current Liabilities Liquidity Ratio (CLLR). As in the case with Urgent Liabilities Liquidity Ratio, CLLR is traditionally calculated as the ratio between net operating cash flows and current liabilities. In the western financial literature, this indicator is called Short-Term Debt Coverage Ratio. The indicator is calculated according to the formula:
CLLR = CFO / (CL-CB)
The indicator should be investigated in the context of the quadrant of interests.
1.3. Long-Term Liabilities Liquidity Ratio (LLLR). The indicator shows the company’s ability to cover long-term debt obligations and loans. The indicator is calculated according to the formula:
LLLR = CFO / (LL-CB)
1.4. Liabilities Liquidity Ratio (LLR). The indicator shows the enterprise’s ability to cover its debt. To calculate it, the average annual value of indebtedness for the period under study is used. The indicator is calculated according to the formula:
LLR = CFO / (L-CB)
1.5. Debt Payment Period or Years Total Debt (YTD). Indicator of the inverse value of coverage coefficients shows the period of debt repayment. It should be investigated not only for the total amount of debt, but also for its types. The indicator can also be explored in terms of quadrant of interests. Therefore, the period of debt repayment can be counted for each of the aforementioned indicators. Formulas for calculations are provided in Table 1.
The way of calculating the debt repayment period by cash flows
|Calculation of indicator|
Years Urgent Liabilities
|YUL = 360 / ULLR (f.8)|
Years Current Liabilities
|YCL = 360 / CLLR (f.9)|
Years Long-Term Liabilities
|YLL = 360 / LLLR (f.10)|
|YL = 360 / LLR (f.11)|
The lower the value of the indicators, the better for the enterprise. Depending on the type of debt, it can be repaid from a few days to several years.
Assets Coverage Ratios allow to assess the enterprise’s ability to generate cash flows. Of these indicators, the profitability of assets and equity is used most often. However, depending on the research object, cash flows can help determine the profitability of various types of the enterprise’s assets. Profitability indicators should be investigated in terms of the quadrant of interests. This allows to assess the efficiency of capital utilization at different stages of the company’s operations.
2.1. Coefficient of Return On Assets (CROA). Return on assets shows the effectiveness of using assets for generating cash flows. If the indicator’s value is high, it shows the enterprise’s assets are effectively used. The coefficient of return on assets by cash flow is calculated according to the following formula:
CROA = CFO / A
The coefficient should be investigated in terms of the quadrant of interests in the cash flow.
2.2. Coefficient of Return On Equity (CROE). Return on equity reflects the efficiency of using own funds to generate cash flows. If the indicator’s value is high, it demonstrates a high equity efficiency. Information for analysis is taken from Balance sheet and average indicators are used for the calculations. The coefficient of return on equity for cash flow is calculated according to the formula as follows:
CROE = CFO / E
The coefficient should be investigated in terms of the quadrant of interests in the cash flow.
2.3. Coefficient of Return on Working Capital (CROWC). Working capital is important in determining the liquidity of an enterprise. It is defined as the difference between current assets and short-term obligations of the enterprise [4, c.208]. In domestic practice [5, 6] the indicator is called the own working capital.
The coefficient of return on working capital by cash flow is calculated according to the formula:
CROWC = CFO / WC
2.5. Coefficient of Return On Intangible Assets (CROIA). Profitability of intangible assets shows the effectiveness of using the intangible assets’ value for generating cash flows. If the value of the indicator is high, the performance of the website is efficient. Information for the analysis is taken from Balance sheet (form №1) and the average indicators are used for the calculations. The Coefficient of Return On Intangible Assets by cash flow is calculated according to the formula:
CROIA = CFO / IA
Ratios of covering investors’ interest estimate the company’s ability to finance its own capital investments at its own expense.
3.1. Capital Expenditure Ratio (CER) assesses the ability of the company to finance capital expenditures (CAPEX) at the expense of operating activities as well as the ability to pay dividends and debts. To calculate the indicator, the same output data as for determining the free cash flow are used. However, the free cash flow reflects the difference between net operating cash flow and capital expenditures, while the Capital Expenditure Ratio defines the CAPEX share. The Capital Expenditure Ratio is calculated according to the formula:
CER = CFO / CAPEX
3.2. Dividend and Long Term Debt Coverage Ratio (DDCR) determines the company’s ability to pay dividend liabilities at the expense of operating cash flows. Dividend and Long Term Debt Coverage Ratio is calculated according to the formula:
DDCR = CFO / (D+CMLTD)
3.3. Capital Expenditures & Cash Dividends Coverage Ratio (CECD) reflects the company’s ability to cover the costs of investing and paying dividends at the expense of operating activities. Formula for calculating the indicator is as follows:
CECD = CFO / (CAPEX + D + CMLTD)
The normal value of an indicator is the one that exceeds 1.
Measurement of cash flows for the enterprises of any activity is aimed at solving specific tasks and satisfy the interests of persons involved in cash flow generation within the enterprise. Different spheres of interests form the so-called “quadrant of interests in the cash flow”, the main idea of which is to create performance indicators important for each participant of the quadrant.
Really, CFO, i.e. the net operating cash flow, is an important indicator for managers responsible for business activity. FCF or free cash flow is an indicator of cash flow efficiency for an investor interested in business development. Borrowers as well as investors working in the long run, are interested in a net free cash flow (NFCF). When it comes to the business owners and the company itself, a net cash flow (CF) is more important. It shows the effectiveness of the entire business, covering organizational, financial and investment activities.
The main purpose of cash flow evaluation is to determine the solvency of an enterprise as well as the efficiency of assets and capital investments. The main indicators of liquidity are the coefficients of net liabilities of the enterprise in terms of their types. The assets coverage ratios can be supplemented and vary depending on the research object.
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If you want to quote this article, please use these references: Kostiuk-Pukaliak, О. (2019) Evaluation of cash flows at different stages of enterprise’s life circle. European multi scientific journal, v.26. PP.37-40