The Cash Return on Assets Ratio is calculated by adding interest payments to Cash Flow from Operating Activities (CFOA) and then dividing by average total assets:
Cash return on assets = CFOA + Interest paid / Average total assets
Cash return on assets measures management’s success,given the assets entrusted to it, in generating cash from operating activities.Because CFOA is available to pay dividends and to finance investments, a high ratio is desirable.
Interest payments are added to CFOA in the numerator for the same reason that interest expense was added to net income in the return on assets calculation discussed in Chapter “Balance Sheet”. That is, cash return on assets is designed to measure management’s success in making operating decisions. Because interest payments are determined by financing decisions, and because they have already been subtracted in calculating CFOA, they are added back.
Altron’s 1997 cash return on assets is( Even though Altron’s statement of cash flows is dated 1998, it is usually referred to as the 1997 statement of cash flows, since the majority of days included in it are from 1997 ):
Cash return on assets
= CFOA + Interest paid
Average total assets
= ( $14,428 + $533)
($155,603 + $134,561) / 2
Altron’s cash return on assets appears reasonable,but it does not compare very favorably to the prior year when operating activities generated $22,686,000 and the cash return on assets was 18.7%.What caused the decline in cash flow? Statements of cash flows prepared under the indirect approach show the adjustments needed to convert net income to cash generated by operations. Altron’s largest adjustment is $10,072,000 for inventory.That is, inventory increased by approximately $10 million and that inventory expansion was essentially funded from operations.The advisability of increasing inventory holdings is usually assessed by comparing the percentage increase in sales to the percentage increase in inventory. Sales increased only 4.3% [($172,428/$165,248) – 1],while inventory increased 54.3% ($28,626/$18,554 – 1). Therefore, the decline in Altron’s cash return on assets raises concerns about its inventory management or the salability of its inventory.
Some analysts question the use of CFOA in cash return on assets and other ratios. Their reservation is that CFOA makes no provision for replacing worn-out equipment. These expenditures are necessary to maintain productive capacity and current operating levels. Because CFOA is not reduced for these expenditures, it overstates the amount of discretionary cash flow generated from operations.
Instead of using CFOA in ratio calculations, some analysts use free cash flow. One way to calculate free cash flow is to subtract from CFOA the cash payment necessary to replace worn-out equipment. Unfortunately, firms rarely disclose this figure. Although the investing activities section of the statement of cash flows shows total payments for the acquisition of productive assets, the amounts spent to replace assets and expand productive capacity are not detailed. Because of this, depreciation expense is sometimes used as an imperfect estimate of the cash expenditure needed to maintain productive capacity. Because depreciation expense is based on historical cost, it probably understates the cash necessary to replace productive assets.