Meaning
The cash flow to debt ratio tells investors how much cash flow the
company generated from its regular operating activities compared to the
total debt it has. For instance if the ratio is 0.25, then the operating
cash flow was one fourth of the total debt the company has on its
books. This debt includes interest payments, principal payments and even
lease payments to cover off balance sheet financing.
Formula
Cash Flow to Debt Ratio = Operating Cash Flow / Total Debt
Assumptions
- Does Not Cover Amortization: The cash flow to debt
ratio assumes interest and principle payments will be paid in the same
manner over the years as they have been paid in this year. This
assumption is implicit in the fact that while calculating total debt
(denominator) we take the interest and principal payments from the
present year financial statements.
However, this may not be the case. Companies have access to a variety
of financing schemes. Some of these schemes include interest only
payments, bullet payments, balloon payments, negative amortization, so
on and so forth. In such innovative amortization, there may be years
when the company has to pay a lot of interest and other years when it
has to pay none. Hence the present years figures may not be indicative
of the future.
- Does Not Cover Lease Increment: Once again,
the ratio takes the lease numbers from the financial statements of the
current year. However, most lease contracts nowadays have lease
increment provisions in them. This means that every year the lease may
go up by a certain percentage. The ratio does not cover this aspect.
Interpretation
- Creditworthiness: Cash flow to debt ratio is the true
measure of the creditworthiness of a firm. This is because a company has
to pay its interest and retire its debt by paying cash. They cannot
pass on the earnings that they may have recorded on accrual basis to
creditors to satisfy their claims. Earlier analysis used earnings
because at that time credit periods were small or nonexistent and
therefore earnings to some extent meant cash flow. However, with the
proliferation of credit, the distinction has been widened. A company may
book earnings immediately and not receive cash for years on end. Thus
creditors have their eyes set on cash flow ratios.
- Analysis of the Past: The cash flow to debt ratio
thus becomes an analysis of how comfortably the company paid its
obligations in the past. The future may or may not be similar. Analysts
have to make adjustments to this ratio to make it more meaningful.
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