The cash flow to debt ratio is a metric that measures the company’s ability to pay off its debt. It can tell you how much money it owes when it comes to the cash flow produced (for all fiscal periods). In fact, this ratio measures how many times in a given year a company would be able to cover its annual interest expense.
In order for this ratio to be considered healthy, it should be greater than 1.5, or else it will signal that the company has trouble paying off its debts and may need additional financing. It is calculated by dividing the cash and cash equivalents on hand by the total liabilities.
But you don’t have to calculate it on your own. Our calculator will do all the work for you. Read on to learn how to use this tool. We will also cover the most important facts about the cash flow to debt ratio and give you some examples to help you get the hang of how it works. Let’s check it out!
What’s the Cash Flow to Debt Ratio?
The cash flow to debt ratio is a financial ratio that compares the enterprise’s cash flow to its debt. It helps measure the company’s ability to pay off its debt. Just like the interest coverage ratio, this metric can reveal the financial health of a company.
Keep in mind that it doesn’t use net income, but CFO (cash flow from operations) since it clearly represents the real earnings. Net income is not used because it’s affected by a variety of non-cash items like amortization and depreciation. By the way, it doesn’t involve any cash flow associated with a decrease or increase in inventory levels.
The cash-to-debt ratio is calculated by dividing the total of cash and cash equivalents by the total of long-term debt and short-term borrowings. As a matter of fact, it is calculated by dividing the cash flow by the total debt and multiplying it by 100. We are going to explain the calculation later. It’s one of several ratios that can be used to measure a company’s liquidity, or ability to meet its obligations as they come due.
For now, you need to know to interpret the results. A high ratio means that a company has more assets than liabilities, which may indicate an ability to weather an economic downturn without having trouble meeting its obligations. On the other hand, a low ratio suggests that the company may have difficulty meeting its obligations in the event of economic hardship.
The higher the ratio, the better it is for a company because it means that it has high liquidity and can easily pay off its debts. The lower ratio means that there is a higher chance of bankruptcy due to a lack of liquidity.
How Do You Calculate the Cash Flow to Debt Ratio?
Now that you have a better idea of the cash flow to debt ratio, you should know how to calculate it. Don’t worry, the calculation is very simple. There are only two components: operating cash flow and total debt.
Cash flow to debt ratio = Operating cash flow / Total debt
To get the cash flow, check your cash flow statement for all the operations. As for the total debt, take a look at the annual or quarterly financial highlights of the reports to find this value. Total debt can also be obtained using this formula:
Total debt = Long term debt + Short term debt
Let’s say you want to calculate the cash flow to debt ratio for a company that has an operating cash flow of $2,947,000,000. And let’s assume its total debt is $13,800,000,000. We will say you find that information in the 4Q 2021 quarter report.
Then the cash flow to debt ratios is as follows: Cash flow to debt ratio = (2,947,000,000 / 13,800,000,000) * 100% = 21.36%
In the next report (1Q 2022), you will find that the total debt is 14,700,000,000 while the operating cash flow is $2,788,000,000. Put these figures in our calculator and you’ll get that the cash flow to debt ratio is about 19%.
As you can see, the cash flow to debt ratio has decreased by around 2.36% in three months. That caused the debt to cash flow to go up, which is a red flag to the company. This means something went wrong and they need to act fast to stop their debt from increasing.
Analysis of the Cash Flow to Debt Ratio
It is necessary to take into account a few fiscal periods to get a proper interpretation of the cash flow to debt ratio. Also, you should do a thorough evaluation in accordance with the trend. The analysis is supposed to cover four possible scenarios:
- Total debt tends to decrease while the operating cash flow increases – If you want to estimate the cash flow to debt ratio, there’s a good probability it’ll rise over time. This means company evolution is likely to be positive.
- Both total debt and operating cash flow go up – In this case, the cash flow to debt ratio is likely to oscillate while maintaining itself. To get a better understanding of the company’s capital structure and trend, you need to do an evaluation for a longer length of time.
- Total debt tends to rise while operating cash flow goes down – What will happen to the cash flow to debt ratio? Well, it will probably grow fast. This is a sign that you don’t need to invest in the company. If you’ve already invested money, sell your positions as soon as possible.
- Both operating cash flow and total debt tend to decrease – While the cash flow to debt ratio will probably be stable down the road, you are advised to sell your positions just in case. That’s because there is a good chance of market capitalization falling in the near future. Our suggestion is to invest in a company only if operating cash flow shows positive growth.