What is the Cash Flow to Debt Ratio?

The cash flow to debt ratio reveals the ability of a business to support its debt obligations from its operating cash flows. This is a type of debt coverage ratio. A higher percentage indicates that a business is more likely to be able to support its existing debt load.

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.

How to Calculate the Cash Flow to Debt Ratio

The calculation is to divide operating cash flows by the total amount of debt. In this calculation, debt includes short-term debt, the current portion of long-term debt, and long-term debt. The formula is:

Cash flow to debt ratio = Operating cash flows ÷ Total debt

A variation on this ratio is to use free cash flow instead of cash flow from operations in the ratio. Free cash flow subtracts cash expenditures for ongoing capital expenditures, which can substantially reduce the amount of cash available to pay off 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.

Assumptions

• Does Not Cover Amortization: The cash flow to debt ratio assumes interest and principle payments will be paid in the same manner over the years as they have been paid in this year. This assumption is implicit in the fact that while calculating total debt (denominator) we take the interest and principal payments from the present year financial statements. However, this may not be the case. Companies have access to a variety of financing schemes. Some of these schemes include interest only payments, bullet payments, balloon payments, negative amortization, so on and so forth. In such innovative amortization, there may be years when the company has to pay a lot of interest and other years when it has to pay none. Hence the present years figures may not be indicative of the future.
  
• Does Not Cover Lease Increment: Once again, the ratio takes the lease numbers from the financial statements of the current year. However, most lease contracts nowadays have lease increment provisions in them. This means that every year the lease may go up by a certain percentage. The ratio does not cover this aspect.

Interpretation

• Creditworthiness: Cash flow to debt ratio is the true measure of the creditworthiness of a firm. This is because a company has to pay its interest and retire its debt by paying cash. They cannot pass on the earnings that they may have recorded on accrual basis to creditors to satisfy their claims. Earlier analysis used earnings because at that time credit periods were small or nonexistent and therefore earnings to some extent meant cash flow. However, with the proliferation of credit, the distinction has been widened. A company may book earnings immediately and not receive cash for years on end. Thus creditors have their eyes set on cash flow ratios.
• Analysis of the Past: The cash flow to debt ratio thus becomes an analysis of how comfortably the company paid its obligations in the past. The future may or may not be similar. Analysts have to make adjustments to this ratio to make it more meaningful.

Example of the Cash Flow to Debt Ratio

A business has a sum total of $2,000,000 of debt. Its operating cash flow for the past year was $500,000. Therefore, its cash flow to debt ratio is calculated as:

$500,000 operating cash flows ÷ $2,000,000 total debt = 25%

The 20% outcome indicates that it would take the organization five years to pay off the debt, assuming that cash flows continue at the current level for that period. When evaluating the outcome of this ratio calculation, keep in mind that it can vary widely by industry.

The cash flow to debt ratio tells investors how much cash flow the company generated from its regular operating activities compared to the total debt it has. For instance if the ratio is 0.25, then the operating cash flow was one fourth of the total debt the company has on its books. This debt includes interest payments, principal payments and even lease payments to cover off balance sheet financing.

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.

Other Considerations

In the calculation of the cash flow to debt ratio, analysts do not typically use the cash flow from financing or cash flow from investing. If the business has a highly leveraged capital structure, it is likely that the business has a fair amount of debt to pay off. It would not make sense to assume that the business was paying off its debt using its debt capital. Therefore, the cash flow from financing is not used in the calculation.

Cash flow from investing activities is also not commonly used in the calculation of the ratio since investing activities are not part of the business’ core cash-generating activities. It is thought better to use a cash flow number that is more representative of the business’ day-to-day activities. Two good options are cash flow from operations or unlevered free cash flow.

Free Cash Flow vs. Cash Flow from Operations

We just noted that the ratio can be calculated using either cash flow from operations or free cash flow. Free cash flow deducts cash expenditures for ongoing capital purchases, which can greatly reduce the amount of cash available to pay off debt.

Problems with the Cash Flow to Debt Ratio

An issue with this ratio is that it does not consider how soon the debt matures. If the maturity date is in the immediate future, then it is entirely possible that a firm will not be able to pay off its debt, despite a robust cash flow to debt ratio.