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Cash Flow to Debt Ratio

Evaluating a company's debt coverage ability

What is the Cash Flow to Debt Ratio?

The cash flow to debt ratio is a coverage ratio that compares the cash flow that a business generates and compares it to the total debt that the business owes. The cash flow used is usually the cash flow from operations, although using the unlevered free cash flow is also a viable option.

Some businesses may opt to use their EBITDA number in the calculation. However, this is not recommended since EBITDA takes into account the businesses’ new inventory purchases, which may take a long time to be sold.

 

Cash Flow to Debt Ratio

 

How to Calculate the Cash Flow to Debt Ratio

The cash flow to debt ratio can be calculated by dividing the business’ debt by its cash flow from operations:

 

Cash Flow to Debt Ratio

 

The cash flow to debt ratio is expressed as a percentage, but can also be expressed in years by dividing 1 by the ratio. It would tell us how many years it would take the business to pay off all of its debt if it were to devote all of its cash flow generated from operations to repay its debt.

The ratio describes the business’ ability to pay off its debt based on its operating cash flow. Another way of thinking is to see how much of the business’ debt would be paid off in one year if all of the company’s operating cash flow was devoted to debt repayment in that year. However, it is unrealistic to think that in any given period, a business would be able to dedicate 100% of its cash earned through operations to debt repayments, since the business likely faces a lot of other costs that need to be met.

Nonetheless, a high cash flow to debt ratio would indicate that the business is in a strong financial position and is able to accelerate its debt repayments if needed. Conversely, a low cash flow to debt ratio would mean that the business may be at a greater risk of not making its interest payments, and may suggest that the business is on a comparably weaker financial footing.

To define what a “high” or “low” cash flow to debt ratio would be, we must compare the cash flow to debt ratio of other companies that operate in the same industry. The ratio can also be looked at historically for a business, which would indicate to us how the business’ debt coverage ability has changed over the course of time.

 

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 fairly leveraged capital structure, it is likely that the business has a fair portion of the debt to pay off. Thus, we can infer that the bulk of the cash flow coming from the business’ financing is in the form of debt financing. It would not make sense to assume that the business was paying off its debt using its debt capital; thus, the cash flow from financing is not used in the calculation.

The 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’ day-to-day cash-generating activities. Thus, it is better to use a cash flow number that is more representative of the business’ day-to-day activities such as the cash flow from operations of unlevered free cash flow.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

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