Cash flow to debt ratio
/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.
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:
Operating cash flows ÷ Total debt = Cash flow to debt ratio
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.
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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 $400,000. Therefore, its cash flow to debt ratio is calculated as:
$400,000 operating cash flows ÷ $2,000,000 total debt = 20%
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.
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
There are several problems associated with the cash flow to debt ratio, which are as follows:
Exclusion of non-operating cash flows. The ratio typically focuses on cash flows from operating activities, which excludes cash from financing and investing activities. While this provides a clear view of core business performance, it omits cash from asset sales, loans, or investments that could temporarily cover debt obligations. This limitation can make a company appear less able to handle its debt than it actually is, particularly if it has other cash sources that can cover debt payments.
Exclusion of capital expenditures. Operating cash flow often doesn’t consider capital expenditures, which are essential for long-term business sustainability. Companies with significant CapEx requirements may appear more capable of handling debt than they truly are, since substantial portions of their cash flow might need to go toward maintaining or growing operations rather than debt repayment.
Ignores cash flow volatility. Cash flows can fluctuate widely due to seasonality, economic cycles, or temporary factors, leading to inconsistencies in the ratio over time. A high cash flow to debt ratio in one period might drop in the next, especially for companies with cyclical revenue. This volatility can make it hard to assess true debt-repayment ability based on a single period’s cash flow.
Simplistic view of debt repayment capacity. The ratio assumes that cash flow can be used solely for debt repayment, ignoring other business expenses or obligations. In reality, companies need to allocate cash for operational needs, dividends, and growth investments, so a high cash flow to debt ratio may not actually mean a company has significant free cash to repay debt.
Does not reflect debt structure. The cash flow to debt ratio does not consider the terms of the debt, such as interest rates, covenants, and maturity dates. This can lead to misleading conclusions about a company's financial health.
In summary, while the cash flow to debt ratio is a useful indicator of a company’s ability to generate cash relative to its debt, these limitations mean it should be considered alongside other financial ratios and metrics for a more complete picture of financial health.