Cash Flow to Debt Ratio

The cash flow to debt ratio is a coverage ratio that reflects the relationship between a company’s operational cash flow and its total debt. Simply put, this metric is often used to determine the length of time required for a company to pay off its debt using its cash flow alone. Cash flow is used instead of earnings, as cash flow is a more accurate gauge of a company’s financial ability.

Yes, it is unlikely that a company would spend all of its operational cash flow to cover its debt. However, the cash flow to debt ratio offers a glimpse into a company’s general financial position. A high ratio shows a business that is highly capable of repaying its debt and taking on more debt if needed.

Another method of determining a company’s cash flow to debt ratio is to examine its EBITDA instead of its cash flow from operations. This option is rarely used as it includes investment in inventory. This may not be sold readily and is therefore not as liquid as cash from operations. Unless there is enough information regarding the composition of a company’s assets, it’s almost impossible to know if a company can pay its debts as easily with the EBITDA method.

On the other hand, an obvious and significant limitation of the formula that uses operating cash flow instead of EBITDA, is its omission of amortization. The cash flow to debt ratio assumes that the method used in making interest and principal payments will be the same, year after year.

Cash Flow to Debt Ratio Formula

$$\text{Cash Flow to Debt} = \dfrac{Operational\: Cash\: Flow}{Total\: Debt}$$

In this formula, debt covers both short-term and long-term debt. The calculation also rarely uses EBITDA (earnings before interest, taxes, depreciation and amortization). 

Total debt calculation considers interest and principal payments from current financial statements. Still, companies can use many different financing schemes, such as making interest-only payments, negative amortization, bullet payments and all the rest. In such cases, the company may pay varying amounts of interest from one year to another, which simply means that present-year numbers may not always reflect future figures.

Another issue with the operating cash flow method is its non-coverage of lease increment. Again, the ratio obtains lease numbers from current-year financial statements. This is despite the fact that lease contracts these days come with increment provisions. That means the lease may increase each year, but the ratio does not take this into account.

Also, in calculating the cash flow to debt ratio, analysts do not usually consider cash flow from financing or from investing. A business with a highly leveraged capital structure will probably have quite an amount of debt to cover. To assume that the company is using its debt capital to wipe out its debt, is illogical. Hence, financing cash flow is excluded from the computation.

Another factor omitted by the operating cash flow method is cash flow from investments, which isn’t considered a core cash-generating activity. Analysts believe it is better to use a cash flow value that more accurately reflects the daily operations of the business, such as cash flow from operations.

Cash Flow to Debt Ratio Example

Suppose DwayneTech’s total debt amounts to $2.5 million, and its operational cash flow for the year totals $625,000. What is the company’s cash flow to debt ratio?

Let’s break it down to identify the meaning and value of the different variables in this problem. 

Now let’s use our formula and apply the values to our variables to calculate the cash flow to debt ratio:

$$\text{Cash Flow to Debt} = \dfrac{625{,}000}{2{,}500{,}000} = 25\%$$

In this case, the tech company would have a cash flow to debt ratio of 25%.

A 25% cash flow to debt ratio means the company will be able to pay one-fourth of its debt yearly, and it would take a total of four years (approximately) to pay off the entire debt, assuming cash flow is consistent. If the company’s ratio were higher, it would indicate a strong fiscal position, considering its cash flow from operations is higher than its total debt. This allows the business to raise the dollar amount of its debt repayments if necessary.

Cash Flow to Debt Ratio Analysis 

Regardless of its limitations, the cash flow to debt ratio comes in handy for several uses. One of these is determining a company’s creditworthiness. A business must repay its interest and retire its debt through cash payments – not earnings, although these were used way back when credit periods were limited or did not exist, and earnings were somehow equivalent to cash flow. With the rise of credit, the difference has become clearer. A business may record earnings instantly without receiving cash until after years, leading today’s creditors to be interested only in cash flow ratios.

Another common use of the cash flow to debt ratio is in the analysis of a company’s past performance in terms of paying off its debts. This may not indicate future performance, but analysts can make changes to the ratio to increase its usefulness.

In any case, it must be noted that operational cash flow is unique from free cash flow. This is sometimes used by analysts because it removes cash spent on capital expenditures. Hence, using free cash flow rather than operational cash flow can indicate that the company is not as capable of covering its financial obligations.

In calculating the cash flow to debt ratio of a company, analysts may also focus on just long-term debt. This offers a more positive take of a company’s financial status if it has considerable short-term debt. In understanding any of these ratios, it should be remembered that they can vary a lot from one industry to another. So a good analysis will compare the ratios of different companies within the same industry.

Cash Flow to Debt Ratio Conclusion

  • The cash flow to debt ratio shows the relationship between a company’s operational cash flow and its total debt.
  • This formula requires two variables: operational cash flow and total debt.
  • The results of this ratio is usually expressed as a percentage.
  • The cash flow to debt ratio is commonly used to assess a company’s creditworthiness
  • It looks at the business’ past credit behavior as a basis for making improvements.
  • The cash flow to debt ratio has limitations, including omitting amortization and lease increment, in the calculation.

Cash Flow to Debt Ratio Calculator

You can use the cash flow to debt ratio calculator below to quickly determine the relationship between a company’s operational cash flow and its total debt, by entering the required numbers.

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