How to Calculate Cash-flow to Debt Coverage Ratio? (Formula, Example, and More)

Definition of Cash-flow to Debt Coverage Ratio

Current Cash Coverage Ratio can be defined as a liquidity ratio that measures the efficiency of an entity’s cash management.

This operating cash ratio measures the percentage of the company’s total debts, which can be covered by the company’s operating cash flow for a given accounting period.

In the definition mentioned above, it can be seen that operating cash flow is the cash generated through the company’s operating activities. This is the main source of cash flow for the company.

The company uses the Operating Cash to Debt Ratio to assess the underlying probability of the company defaulting on the given interest payments.

In the case where the company generates a substantial amount of cash, makes it easier, and convenient for the company to repay its debts. Therefore, it is considered to be a safer investment by the creditors of the company.

Importance of calculating Cash Flow to Debt Coverage Ratio

There are three main reasons as to why companies calculate Cash Flow to Debt Coverage Ratio. These reasons are as follows:

  • To measure how much cash a company generates relative to the total debt position of the company.
  • It helps in quantifying a company’s probability of default.
  • It is considered to useful determine debt related parameters. Based on the inherent risk involved, investors, and the organization can then determine the way forward in terms of terms and conditions mentioned in the debt contract.

Based on the factors mentioned earlier, it can be seen that companies calculate this ratio for internal and external reasons.

Formula for calculating Cash-Flow to Debt Coverage Ratio

Cash Flow to Debt Coverage Ratio is calculated using the following formula:

Cash Flow to Debt Coverage: Cash Flow from Operations / Total Debt of the company, where

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Cash Flow from Operations is defined as the cash flow that the business is able to generate from its operating activities. This is mostly found on the company’s cash flow statement.

Total Debt mostly refers to the amount of debt that the company has. This is mostly found by adding up the company’s short-term as well as long-term debt. These figures are found on the Balance Sheet of the company.

Free Cash Flow vs Cash Flow from Operations

The Cash Flow to Debt Ratio is used to calculate the Cash Flow to Total Debts. In this regard, analysts investigate the ratio of cash flow to long-term debt.

This ratio mostly provides a more favorable snapshot of the company’s financial health in the case where they have taken on a significant amount of debt for a short-term.

Some analysts prefer using Free Cash Flow vs Cash Flow from Operations when calculating Cash flow to Debt Equity Ratio.

Free Cash Flow mainly subtracts capital expenditures from the cash flows, indicating that the company is relatively less equipped to meet its financial obligations.

When examining either of these ratios, it is also important to recall the fact that these ratios vary widely across different industries. Therefore, they can only be used comparatively, which can help companies prepare different analyses based on other companies and their results.

Interpretation of Cash Flow to Debt Coverage Ratio

Under most circumstances, a higher Cash Flow indicates that a company is fairly mature since it generates substantial cash from operating activities.

Therefore, higher cash flow ratios are indicative of better reserves with the company that can somewhat ensure and guarantee that the creditors are likely to pay the amount back to the creditors.

Hence, debt providers are supposed to lend money to companies that have a relatively higher Cash Flow to Debt Coverage Ratio. In this regard, it is also important to consider the fact that there is not always a particular stand-alone number, but it is often used when there is a need to draw comparisons between different companies.

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For example, a company with a Cash to Debt Ratio equivalent to 0.7 would be more preferred as compared to companies with a Cash to Debt Ratio equivalent to, let’s say, 0.2.

Example of Cash flow to Debt Ratio

The concept of Cash Flow to Debt Ratio is illustrated in the following example:

Bear and Co. is a trading concern. It has a fair amount of leverage (debt) on its balance sheet, in addition to the equity that different shareholders in the company own. The total debt taken on by Bear and Co. amounted to $1,250,000. On the contrary, the cash flow to operations for the year ended amounted to $300,000.

In the scenario mentioned above, it can be seen that Cash Flow to Debt Ratio can be calculated as follows:

Cash Flow to Debt = $300,000 / $1,250,000 = 0.24

The ratio of 0.24 (or 24%) indicates that assuming stable and constant cash flows, it takes approximately a timeline of 4 years to repay the debt since the ratio is around 25%. This is double-checked by verifying the number by dividing it by 1.

Dividing 1 by the ratio (24%) gives an amount of 4.17 years. This further confirms that the company would take around 4 years in order to pay back the debt.

In the case where Bear and Co. had a higher ratio result when comparing cash flow to the company’s debt position, it would be an indication of a stronger financial position of the business that is likely to increase the actual payment of the debt repayments, if required.

What does the Cash Flow to Debt Ratio indicate?

It is highly unlikely for a company to divert all the resources from the company’s cash flow towards the repayment of the debt. Regardless of this, Cash Flow to Debt Ratio is particularly resourceful in providing a much-needed snapshot of the overall financial health of the company.

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A higher ratio in this regard is indicative of a company being able to pay back the debt, and in this aspect, it is then considered safer in taking on more money.

Another way of considering this calculation is to study the company’s EBITDA compared to the cash flow derived from operations.

This particular option is used quite less, primarily because of the fact that it includes investment in inventory, and in the case where inventory is not sold in a rapid manner, it is no longer supposed to be considered as a liquid resource from cash flow from operations.

Therefore, managerial accountants and investors rely on the Cash Flow to Debt Ratio to determine debt obligations using the EBITDA methodology.

Problems Associated with Cash flow to Debt Coverage Ratio

The main underlying issue associated with the Cash Flow to Debt Ratio is the fact that it does not consider how soon the debt matures.

In the case where the maturity date is placed in the future, it is possible that a firm does not pay off its debt, regardless of having a satisfactory cash flow to debt ratio.

Therefore, from the perspective of the company, it is important to note that the Cash Flow to Debt Coverage Ratio tends to be used for a holistic picture of the company’s financial standing. It cannot, however, be relied upon in its entirety.