The cash flow on total assets ratio is calculated by:
A) Dividing cash flows from operations by average total assets.
B) Dividing total cash flows by average total assets.
C) Dividing average total assets by cash flows from financing activities.
D) Dividing average total assets by total cash flows.
E) Total cash flows divided by average total assets times
The correct answer and explanation is :
The correct answer is:
A) Dividing cash flows from operations by average total assets.
Explanation:
The cash flow on total assets ratio is a key financial metric that measures a company’s ability to generate cash from its operations relative to its total assets. It provides insights into how efficiently a company is utilizing its assets to produce operating cash flow, which is critical for financial health and sustainability.
The formula for calculating the ratio is:
[
\text{Cash Flow on Total Assets Ratio} = \frac{\text{Cash Flows from Operations}}{\text{Average Total Assets}}
]
Where:
- Cash Flows from Operations (CFO) represents the cash a company generates from its core business activities. It is obtained from the operating section of the statement of cash flows and excludes investing and financing activities.
- Average Total Assets is the average of the total assets at the beginning and end of a period, calculated as: [
\text{Average Total Assets} = \frac{\text{Beginning Total Assets} + \text{Ending Total Assets}}{2}
]
This ratio is useful because:
- Efficiency Measurement: It helps investors and analysts assess how effectively a company converts its asset base into cash flow.
- Liquidity Insight: A higher ratio indicates strong operational cash generation, which can be used for reinvestment, debt repayment, or dividend distribution.
- Comparative Analysis: It allows comparisons between companies in the same industry, revealing differences in cash flow efficiency.
For example, if a company has operating cash flows of $500,000 and average total assets of $2,000,000, the ratio would be:
[
\frac{500,000}{2,000,000} = 0.25 \text{ (or 25%)}
]
This means the company generates 25 cents in operating cash flow for every $1 of assets. A higher ratio is generally preferred, indicating better asset efficiency.