Cash Flow-to-Debt Ratio

The Cash Flow-to-Debt Ratio designates the company's capability to cover its total debt with yearly cash flow from operations. A high cash flow to debt ratio gives the company a great position to cover total debt. This formula's type is debt measure ( M.Rist, A.J.Pizzica, Penhagenco LLC 2014, p.25). The Cash Flow-to-Debt Ratio is accustomed to establish the quantity of cash flow possible to pay down fixed debt payment responsibilities. A ratio well above one is a type of owning not only enough funds to meet debt repayment needs but also of supporting more debt commitments if essential (S.M.Bragg 2003, p.64).

Formula of Cash Flow-to-Debt Ratio

The formula of Cash Flow-to-Debt Ratio is presented as:

$CashFlow-to-DebtRatio={\frac {Operatingcashflow}{Totaldebt}}$

Example of Cash Flow-to-Debt Ratio

A very simple example is shown by Michael Rist, Albert J. Pizzica and Penhagenco LLC and it reads as follows: "ABC Company has cash flow from operations in the amount of $8,145 and total debt ( short term and long term) in the amount of $22,005. This gives a debt ratio of 0.37.

$CashFlow-to-DebtRatio={\frac {8,145}{22,005}}=0.37$

A cash flow to debt ratio of 0.37 indicates that it will take the company over three years (i.e., 3.7 times) to cover its total debt. This number can be compared to industry averages or other companies to compare debt loads." ( M.Rist, A.J.Pizzica, Penhagenco LLC 2014, p.25)

Debt ratios

Debt ratios measure the company's total debt load and the mix of assets and debt. Debt ratios provide us a look at the company's leverage ratio. Debt ratios can be fine, bad, or neutral, depending on many determinants containing who is asking. As an example, a high overall debt ratio may be good for shareholders not wanting to reduce their shares but bad for the mortgagers of the company. The most common debt ratios except Cash Flow-to-Debt Ratio involve the following (M.Rist, A.J.Pizzica, Penhagenco LLC 2014, p.5):

• Asset to equity
• Interest coverage
• Debt ratio
• Asset turnover
• Debt to equity
• Equity multiplier

Advantages of Cash Flow-to-Debt Ratio

The Cash Flow-to-Debt Ratio is a measure of a company's ability to pay off its debt obligations with its cash flow from operations. It is an important indicator of a company's financial health and sustainability. Here are some advantages of using the Cash Flow-to-Debt Ratio for financial management:

• It gives an indication of a company's short-term liquidity and ability to pay off its debt obligations.
• It can be used to compare a company's financial position with its peers, helping to identify potential areas of improvement.
• It helps to quickly identify cash flow problems that might be present in a company.
• It can be used to measure the effectiveness of a company's financial management strategies.
• It provides information that can be used to identify potential risks to a company's financial health.
• It can help to identify potential opportunities to increase cash flow.

Limitations of Cash Flow-to-Debt Ratio

The Cash Flow-to-Debt Ratio is a useful financial metric to measure the ability of a company to cover its short-term debt obligations. However, it is also subject to certain limitations. These include:

• A company may have a high cash flow-to-debt ratio but still be in financial distress due to high fixed costs. This is because the cash flow-to-debt ratio does not consider long-term debt or other non-operational costs such as taxes, interest, and depreciation.
• The cash flow-to-debt ratio does not take into account the quality of the cash flow. A company may have a high cash flow-to-debt ratio due to one-off sales or non-recurring income, but if these are not sustainable, the company may still be in financial distress.
• The cash flow-to-debt ratio may be affected by non-cash expenses, such as depreciation. These are not taken into account in the calculation of the ratio, and may lead to an artificially high ratio.
• The cash flow-to-debt ratio does not distinguish between short-term and long-term debt. A company may have a high cash flow-to-debt ratio but be in financial distress due to high long-term debt.
• The cash flow-to-debt ratio does not take into account potential future debt obligations. A company may have a high cash flow-to-debt ratio in the short-term, but may not be able to cover its future debt obligations.

Other approaches related to Cash Flow-to-Debt Ratio

Other approaches related to Cash Flow-to-Debt Ratio include:

• Debt Service Coverage Ratio - a measure of a company's ability to pay its current debt obligations from its current income. This ratio is calculated by dividing net operating income by total debt service.
• Debt-to-Equity Ratio - a measure of a company's financial leverage, calculated by dividing total debt by total equity. A higher ratio indicates an increase in leverage and a higher risk for the company.
• Interest Coverage Ratio - a measure of a company's ability to pay its interest obligations from its current income. This ratio is calculated by dividing Earnings Before Interest and Tax (EBIT) by Interest Expense.
• Cash Coverage Ratio - a measure of a company's ability to pay its current liabilities from its current cash flow. This ratio is calculated by dividing Cash Flow from Operating Activities by Total Current Liabilities.

In summary, Cash Flow-to-Debt Ratio is one of the many financial ratios used to evaluate a company's financial position and performance. Other approaches include Debt Service Coverage Ratio, Debt-to-Equity Ratio, Interest Coverage Ratio, and Cash Coverage Ratio.

Cash Flow-to-Debt Ratio — recommended articles

Solvency ratios — Coverage ratio — Debt to total assets ratio — Capitalization ratio — Capitalization ratios — Ebitda ratio — Debt management ratio — Fixed-Charge Coverage Ratio — Capital gearing

References

• Asquith P., Weiss L.A., (2019), Lessons in Corporate Finance: A Case Studies Approach to Financial Tools, Financial Policies, and Valuation' , John Wiley & Sons, Hoboken
• Bragg M.S., (2003), Business Ratios and Formulas: A Comprehensive Guide , John Wiley & Sons, Hoboken
• Dorrell D.D., Gadawski A.G., (2012), Financial Forensics Body of Knowledge , John Wiley & Sons, Hoboken
• Frederikslust van R.A.I, (2012), Predictability of corporate failure: Models for prediction of corporate failure and for evaluation of debt capacity , Springer Science & Business Media, Boston
• McLean R., (2002), Financial Management in Health Care Organizations, Cengage Learning, Canada
• Rist M., Pizzica J.A., Penhagenco LLC., (2014), Financial Ratios for Executives: How to Assess Company Strength, Fix Problems, and Make Better Decisions , Apress, New York
• Stickney P.C., Weil L.R., Schipper K., Francis J., (2009), Financial Accounting: An Introduction to Concepts, Methods and Uses , Cengage Learning, Canada
• Vernimmen P., Quiry P., Dallocchio M., Le Fur Y., Salvi A., (2014), Corporate Finance: Theory and Practice , John Wiley & Sons, Great Britain

Author: Paulina Zając