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
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. Thus, a lender might look at this ratio and assume that a borrower is in a strong position to pay off a loan, and then receives a frantic call from the borrower, asking to roll forward the debt to a later payment date.