cash flow coverage ratio

Cash Flow Coverage Ratio

Naturally, a company must be able to pay off its obligations with the operating cash flows it has. This ability is measured with the help of a liquidity ratio that’s known as cash flow coverage.

More specifically, the cash flow coverage ratio shows if a company is able to pay off its current expenses or debt with its cash flow from operations – simple! This ratio shows the available amount of money for a certain company to meet its current obligations.

Due to the fact that it shows how many times earnings can cover certain obligations, such as interest on short-term notes, rent, and preferred dividends, this ratio is seen as being multiple – it is a visualization of current liquidity.

What Is the Cash Flow Coverage Ratio?

The cash flow coverage ratio measures the percentage of a business total liabilities, commonly long term, that are covered by its annual operating cash flow. This metric can also indicate how many years it will take the company to cover for its entire debt if it could sustain the current cash flow situation.

The cash flow coverage ratio represents the relationship between a company’s operating cash flow and its total debt. It serves as a metric that determines a company’s ability to pay its liabilities within a certain period.

When computing the cash flow coverage ratio, analysts rarely use cash flow from financing or investing. A business with a well-leveraged capital structure often has a fair volume of debt to settle. That it would use its debt capital to wipe out its debt is unlikely; hence, financing cash flow is never involved in the calculation. Investing cash flow is not typically used in calculating the ratio either, considering investing activities are outside a business’ key cash-yielding processes.

Experts advise using a cash flow value that most accurately reflects the business’ fiscal position, and that is none other than cash flow derived from the company’s actual daily operations. Needless to say, accuracy in calculating this value is critical as errors can lead to wrong decisions that can complicate the company’s financial position, especially if it is already struggling with debt.

Understanding the Cash Flow Coverage Ratio

A business capacity to cover for its debt is essential information for shareholders, investors, lenders and any other stakeholder. By calculating the Cash Flow Coverage ratio an analyst can understand what’s the current situation of the business in terms of generating enough cash to cover for its debt obligations.

Usually this metric is related to the repayment of principal and not the payment of interest charges, as those are measured through the interest coverage ratio. On the other hand, interest expenses are part of the income statement and are deducted directly from revenues, while the principal payments are reflected in the Cash Flow Statement.

A business that has a high Cash Flow Coverage Ratio is more likely to be able to cover for its debt commitments than one with a low ratio.

Using this kind of measurement, stakeholders, creditors, and investors are shown an overview of the operating efficiency of a certain company. A huge cash flow ratio means that a company can do whatever it wants – as they appear to have infinite amounts of cash.

For example, if you would like to relate this ratio to your own personal life, you could think of it as that little extra at the end of the month – after you’ve paid your rent and bills – that you can safely put away in your savings account.

On the other hand, if a company has a sufficient cash flow coverage ratio, the latter can pose as a safety net, ready to support the company if the business cycles get slower.

If you own a business, you can be sure that a bank will check this ratio if you want to make a loan for the said business. This is done in order to determine the repayment risk they would take if they are to approve your loan.

The Formula of the Cash Flow Coverage

The Cash Flow Coverage Ratio formula is calculated below:

CFCR = Cash Flow from Operations ÷ Total Debt

To obtain this metric, the sum of the company’s non-expense costs is divided by the cash flow for the same period. This includes debt repayment, stock dividends, and capital expenditures.

The cash flow would include the sum of the business’ net income. You can also use EBITDA (earnings before interest, taxes, depreciation, and amortization) in place of operating cash flows.

The ideal ratio is anything above 1.0. However, the types of debt payments involved in the computation should also be taken into account. This is especially true if the company’s debt for the studied period is extraordinarily large. Conversely, a ratio lower than 1.0 shows that the business is generating less money than it needs to cover its liabilities and that refinancing or restructuring its operations could be an option to increase cash flow.

In some cases, other versions of the ratio may be used for other debt types. For example, to compute for short-term debt ratio, operating cash flow is divided by short-term debt; to calculate dividend coverage ratio, operating cash flows are divided by cash dividends; and so on. For the cash flow coverage ratio, only cash flow from operations should be used for maximum accuracy.

Cash Flow Coverage Equation Components

Cash Flow from Operations: Net income plus depreciation and amortization charges plus any positive or negative changes in working capital.

Total Debt: The nominal value of all the long term debt carried by the business.

While the result can be expressed as a percentage of the total debt it could also be expressed in the number of years it will take the company to cover its debt, by using this formula:

Years to Cover Entire Debt = 1 ÷ CFCR

There are several variations to this formula, and it will depend on the analyst intention. For example, total debt can be changed by debt commitments that will mature in the next 12 months. Or it could also consider the entire debt including short term and long term.

On the other hand, Free Cash Flow could be exchanged for Cash Flow from Operations if essential capital expenditures need to be deducted from the operating cash flow to get a more accurate coverage ratio.

Cash Flow Coverage Ratio Analysis

The Cash Flow Coverage Ratio is a good metric that companies can use to help assess their fiscal position. They can check it before making crucial decisions like when to pursue or hold off expansion plans; how to improve their debt management strategies; or to determine whether or not resources are used properly for maximum cash flow.

A company needs to monitor its cash flow for long-term fiscal health. One of the ways to do that is by calculating its cash flow coverage ratio. This metric can be used alongside other indicators, such as fixed charge coverage, and can be crucial for companies that are mired in debt or undergoing rapid growth.

In any case, when the cash flow coverage ratio is high, that means the business is financially solid and has the capacity to fast-track its debt repayments if needed. Accelerating debt repayments allows the company to use more of its profits sooner for added capital and increased cash flow. Conversely, a low ratio means there is a good chance the business will fail with interest payments. This generally means the business is financially weak.

A cash flow coverage ratio serves more purposes in the world of business. Aside from being a good indicator of a company’s ability to pay off its liabilities, bankers and lenders may also use it to assess a business entity’s credit-worthiness. For investors and creditors, it helps determine whether or not dividends and loans will likely be paid on time. Usually considered last during business liquidation, shareholders can refer to this number to calculate dividends and decide if they should receive more. A higher ratio usually means more dividends for distribution).

Overall, the cash flow coverage ratio examines a company’s income and whether or not resources are being maximized to produce the best potential operating cash flow. This insight also helps decision-makers weigh factors that affect both their short-term and long-term operations and goals. In addition, it provides a historical perspective on the business. For instance, how its debt-payment ability has improved over time, or what can be done to improve it.

Cash Flow Coverage Uses, Cautions, Pitfalls

While the formula commonly employs Operating Cash Flows to estimate the coverage rate, in some cases, it would be advisable to employ Free Cash Flow instead, especially if the business is a capital intensive one.

The reason for this is that capital intensive companies constantly need to make large capital expenditures to sustain their operations. Therefore, the operating cash flow by itself may overestimate the business’ actual capacity to cover for the debt. Capital expenditures must be deducted from the operating cash flow to provide a more realistic cash flow figure that will actually reflect the funds available for debt.

That being said, capital expenditures that are understood to be non-recurring should not be deducted from operating cash flow, as they will have the opposite effect, which is that they will underestimate the ratio and therefore the business apparent capacity to fulfill its debt.

Lending is not the only time cash flow coverage becomes important. Investors also want to know how much cash a company has left after paying debts. After all, common shareholders are last in line in liquidation, so they tend to get antsy when most of the company’s cash is going to pay debtors instead of raising the value of the company.

Shareholders can also gauge the possibility of cash dividend payments using the cash flow coverage ratio. If a company is operating with a high coverage ratio, it may decide to distribute some of the extra cash to shareholders in a dividend payment.

Using this in conjunction with other financial calculations, such as return on retained earnings, investors can get a better sense of how well the company is using the earnings it generates. Ultimately, if the cash flow coverage ratio is high, the company is likely a good investment, whether return is seen from dividend payments or earnings growth.

Leave a Reply

Your email address will not be published.