The cash flow coverage ratio measures the percentage of a business total liabilities, commonly long term, that are covered by its annual operating cash flow. This metric can also indicate how many years it will take the company to cover for its entire debt if it could sustain the current cash flow situation.
What is the Cash Flow Coverage Ratio?
Contents
A business capacity to cover for its debt is essential information for shareholders, investors, lenders and any other stakeholder. By calculating the Cash Flow Coverage ratio an analyst can understand what’s the current situation of the business in terms of generating enough cash to cover for its debt obligations.
Usually this metric is related to the repayment of principal and not the payment of interest charges, as those are measured through the interest coverage ratio. On the other hand, interest expenses are part of the income statement and are deducted directly from revenues, while the principal payments are reflected in the Cash Flow Statement.
A business that has a high Cash Flow Coverage Ratio is more likely to be able to cover for its debt commitments than one with a low ratio.
Cash Flow Coverage Formula
The Cash Flow Coverage Ratio formula is calculated below:
CFCR = Cash Flow from Operations / Total Debt
Cash Flow Coverage Equation Components
Cash Flow from Operations: Net income plus depreciation and amortization charges plus any positive or negative changes in working capital.
Total Debt: The nominal value of all the long term debt carried by the business.
While the result can be expressed as a percentage of the total debt it could also be expressed in the number of years it will take the company to cover its debt, by using this formula:
Years to Cover Entire Debt = 1 / CFCR
There are several variations to this formula, and it will depend on the analyst intention. For example, total debt can be changed by debt commitments that will mature in the next 12 months. Or it could also consider the entire debt including short term and long term.
On the other hand, Free Cash Flow could be exchanged for Cash Flow from Operations if essential capital expenditures need to be deducted from the operating cash flow to get a more accurate coverage ratio.
Cash Flow Coverage Example
American Glass is a company that produces glass panels for windows and vehicles. They are heavily indebted, yet the Chief Financial Officer claims they are in a good position to cover for all the company’s financial commitments. Yet, the CEO wanted to corroborate this information and he decided to run some calculations himself with the following information:
Information from last year’s annual report:
Cash Flow from Operations: $12,563,000
Capital Expenditures: $1,340,000
Total Long Term Debt: $76,000,000
By using this information, the CEO can calculate the Cash Flow Coverage Ratio:
CFCR = $12,563,000 / $76,000,000 = 16.5%
He can also estimate the number of years it will take the business to cover for its entire debt:
Years to Cover = 1 / 0.165 = 6 years
A 16.5% is not necessarily a positive or negative figure. Instead, the number of years it takes for the cash flow to cover the entire principal of the outstanding debt does give some insights on the business’ capacity to fulfill its financial commitments. For example, if the business currently has loans that are due in less than 5 years, the CEO should review the past 5 years of cash flows at least to determine if the cash flow generated by the business during those periods of time combined is healthy enough to fulfill these commitments.
Cash Flow Coverage Ratio Analysis
Drafting conclusions from the Cash Flow Coverage Ratio is not as easy as it seems. First, the result is a percentage of the debt, but since it is tracked annually and debts have different maturity dates, its hard to understand if 20%, which is a 5-year full coverage timeline, is a good enough result, if the average maturity date of the company’s debt is 6 or 7 years. This also happens because the annual picture doesn’t look back to previous periods either.
Basically, the best approach to this metric is to understand if the business is generating enough cash flow to potentially cover its debt commitments in the future. Nevertheless, the actual capacity to cover for these commitments in the short term, can be more accurately estimated by figuring how much of that debt is due in the next 12 months.
In that case, the Cash Flow Coverage Ratio should be high, as it will eventually help in covering for those commitments. Yet, it will still fail to provide a picture of how fit the business is to cover for it in practice, as the business could have sinking funds and cash reserves from previous periods that have been accumulated to cover for the upcoming payments.
For this reason, while the metric may be useful to provide an estimation of the performance of the business in terms of how much cash it generates to cover for its debt, it should not be employed to specifically estimate its capacity to fulfill those commitments in the short term.
Cash Flow Coverage Uses, Cautions, Pitfalls
While the formula commonly employs Operating Cash Flows to estimate the coverage rate, in some cases, it would be advisable to employ Free Cash Flow instead, especially if the business is a capital intensive one.
The reason for this is that capital intensive companies constantly need to make large capital expenditures to sustain their operations. Therefore, the operating cash flow by itself may overestimate the business’ actual capacity to cover for the debt. Capital expenditures must be deducted from the operating cash flow to provide a more realistic cash flow figure that will actually reflect the funds available for debt.
That being said, capital expenditures that are understood to be non-recurring should not be deducted from operating cash flow, as they will have the opposite effect, which is that they will underestimate the ratio and therefore the business apparent capacity to fulfill its debt.