Definition of the cash flow to debt ratio

What is the cash flow to debt ratio?

The cash flow to debt ratio is the ratio of the cash flow from operating a business to its total debt. This ratio is a type of coverage ratio and can be used to determine how long it would take a business to pay off debt if it spent all of its cash flow on debt repayment. Cash flow is used rather than profit because cash flow provides a better estimate of a company’s ability to meet its obligations.

The cash flow to debt ratio formula














Cash flow to debt


=




Cash flow from operations




Total debt










begin {aligned} & text {Cash flow to debt} = frac { text {Cash flow from operations}} { text {Total debt}} end {aligned}



Cash flow to debt=Total debtCash flow from operations

The ratio is less frequently calculated using EBITDA or free cash flow.

Key points to remember

  • The cash flow to debt ratio compares the cash flow generated by operating a business to its total debt.
  • The cash flow-to-debt ratio indicates how long it would take a business to pay off all of its debt if it used all of its operating cash flow to pay off debt (although this is a scenario very unrealistic).

What can the cash flow to debt ratio tell you?

While it is unrealistic for a business to devote all of its operating cash flow to paying down debt, the cash flow to debt ratio provides insight into the overall financial health of a business. A high ratio indicates that a company is better able to repay its debt, and therefore is able to take on more debt if necessary.

Another way to calculate the cash flow to debt ratio is to look at a company’s EBITDA rather than cash flow from operations. This option is less often used because it includes investing in inventory, and since inventory may not be sold quickly, it is not considered as liquid as cash from operations.

Without more information on the composition of a company’s assets, it is difficult to determine whether a company is so easily able to cover its debts using the EBITDA method.

The difference between free cash flow and cash flow from operations

Some analysts use free cash flow instead of operating cash flow because this metric subtracts cash used for capital expenditures. Using free cash flow instead of cash flow from operations may therefore indicate that the business is less able to meet its obligations.

The ratio of cash flow to debt examines the ratio of cash flow to total debt. Analysts sometimes also look at the ratio of cash flow to long-term debt. This ratio can give a more favorable picture of a company’s financial health if it has incurred significant short-term debt. When considering either of these ratios, it’s important to remember that they vary widely from industry to industry. A proper analysis should compare these ratios with those of other companies in the same industry.

Example of using the cash flow to debt ratio

Assume that ABC Widgets, Inc. has total debt of $ 1,250,000 and operating cash flow for the year of $ 312,500. Calculate the company’s cash flow to debt ratio as follows:














Cash flow to debt


=




$


3


1


2


,


5


0


0




$


1


,


2


5


0


,


0


0


0




=


.


2


5


=


2


5


%








begin {aligned} & text {Cash Flow to Debt} = frac { $ 312.500} { $ 1.250.000} = .25 = 25 % end {aligned}



Cash flow to debt=$1,250,000$312,500=.25=25%

The result of the company’s 25% ratio indicates that, assuming it has a stable and constant cash flow, it would take about four years to pay off its debt since it would be able to pay back 25% every year. Dividing the number 1 by the result ratio (1 / 0.25 = 4) confirms that it would take four years to pay off the company’s debt.

If the company had a higher ratio score, with its operating cash flow higher than its total debt, this would indicate a financially stronger company that could increase the dollar amount of its debt repayments if necessary. .


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John A. Bogar

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