Understanding the Cash Flow-to-Debt Ratio: Definition, Formula, and Examples

What Is the Cash Flow-to-Debt Ratio?

The cash flow-to-debt ratio reveals how effectively a company can use its operational cash flow to handle its total debt. This important coverage ratio estimates how long it would take to repay all debt using only cash flow from operations, offering a more reliable perspective than earnings alone.

How to Calculate the Cash Flow-to-Debt Ratio

$\begin{aligned} &\text{Cash Flow to Debt} = \frac{ \text{Cash Flow from Operations} }{ \text{Total Debt} } \\ \end{aligned}$​Cash Flow to Debt=Total DebtCash Flow from Operations​​

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

Understanding Insights From the Cash Flow-to-Debt Ratio

Although a company is unlikely to use all its cash flow for debt repayment, the cash flow-to-debt ratio offers a quick view of its financial health. A high ratio indicates that a company is better able to pay back its debt, and is thus able to take on more debt if necessary.

You can also calculate the cash flow-to-debt ratio using a company’s EBITDA instead of cash flow from operations. This option is used less often because it includes investment in inventory, and since inventory may not be sold quickly, it is not considered as liquid as cash from operations.

Without more details about a company’s assets, it’s hard to know if it can cover debt using EBITDA.

Comparing Free Cash Flow and Cash Flow From Operations

Some analysts prefer using free cash flow since it subtracts cash spent on capital expenditures. Using free cash flow might suggest the company is less able to meet its obligations.

The cash flow-to-debt ratio compares cash flow to total debt. Analysts sometimes look at the ratio to just long-term debt. This ratio may provide a more favorable picture of a company's financial health if it has taken on significant short-term debt. When examining these ratios, remember they vary widely across different industries. Proper analysis involves comparing these ratios with those of other companies in the same industry.

Practical Example of Using the Cash Flow-to-Debt Ratio

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

 $\begin{aligned} &\text{Cash Flow to Debt} = \frac{ \$312,500 }{ \$1,250,000 } = .25 = 25\% \\ \end{aligned}$​Cash Flow to Debt=$1,250,000$312,500​=.25=25%​

The company's ratio result of 25% indicates that, assuming it has stable, constant cash flows, it would take approximately four years to repay its debt since it would be able to repay 25% each year. Dividing the number 1 by the ratio result (1 / .25 = 4) confirms that it would take four years to repay the company's debt.

If the company had a higher ratio result, with its cash flow from operations higher relative to its total debt, this would indicate a financially stronger business that could increase the dollar amount of its debt repayments if needed.

The Bottom Line

The cash flow-to-debt ratio is a crucial metric for assessing a company's ability to repay its debt using its operational cash flow. This coverage ratio provides a comprehensive snapshot of a company's financial health, aiding in the understanding of how swiftly it can manage its debt obligations. A higher ratio suggests a stronger financial position, allowing companies to take on additional debt if required. However, this must be contextualized within industry norms, as variations can occur. By calculating the ratio using cash flow from operations rather than EBITDA or free cash flow, analysts can gain a more accurate insight into a company's debt repayment capability."