What Is the Cash Flow-to-Debt Ratio?

How to Calculate the Cash Flow-to-Debt Ratio

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The cash flow-to-debt ratio is a comparison of a company's operating cash flow to its overall debt.

Learn how to calculate the cash flow-to-debt ratio, how to interpret it, and its limits. Plus, see an example of how the ratio can be used to figure out if a firm can pay its debts.

Definitions and Examples of the Cash Flow-to-Debt Ratio

The cash flow-to-debt ratio measures a company's cash flow from operations in relation to its total debt. It's useful because it tells you how much money a firm made in an accounting period from operating the business as opposed to receiving money from loans or investments.

How Do You Calculate the Cash Flow-to-Debt Ratio?

To calculate a company's cash flow-to-debt ratio, first figure out its annual operating cash flow. This is one of the three cash flows listed on the cash flow statement. Operating cash flow is calculated as Earnings Before Interest and Taxes (EBIT), plus depreciation, minus taxes. The EBIT itself amounts to the net annual income, plus interest expenses, plus income tax expenses.

Next, add up current and long-term liabilities (shown on the firm's balance sheet) to figure the total debt.

Lastly, divide the operating cash flow by the total debt to obtain the cash flow-to-debt ratio.

Cash flow-to-debt ratio equation

Some firms use free cash flow instead of operating cash flow. Free cash flow amounts to operating cash flow, minus net working capital, minus net capital spending.

How the Cash Flow-to-Debt Ratio Works

The ratio tells you two things about a company:

  • Its capacity to repay its debts: The higher the ratio, the more able a firm is to pay off debts.
  • The length of time needed to repay its debts: Dividing 1 by the cash flow-to-debt ratio tells you how many years it will take to pay off its total debt.

A ratio of 1 or greater is best, whereas a ratio of less than 1 shows that a firm isn't generating sufficient cash flow—and doesn't have the liquidity—to meet its debt obligations. This is key, as a firm that may not be able to pay its debts is headed for trouble and may not be a stock you want to own.

For instance, let's say that ABC Corp. has an operating cash flow of $5 billion but has $20 billion in total debt. It has a cash flow-to-debt ratio of 0.25, which means it would take a whopping four years to pay off its debt (1 divided by 0.25).

XYZ Corp., in contrast, has an operating cash flow of $20 billion and is only $16 billion in debt. Its cash flow-to-debt ratio is a more solid 1.25. It can repay its debt in less than 10 months. It may even be able to pay down its debt faster through larger payments. Or, it could take on more debt and expand the company.

During tough economic times, cash flow can suffer. This prevents debt repayment or a decrease in total debt. The larger the cash flow-to-debt ratio, the better a firm can weather rough patches.

Limitations of the Cash Flow-to-Debt Ratio

The ratio has two key constraints:

Diverse Methods of Calculation

The variables used to figure out the ratio are not set in stone. If an analyst uses free cash flow instead of operating cash flow, for instance, the calculation excludes working capital and capital spending. These may be substantial for a growing company. Likewise, if only long-term debt is factored into the debt calculation, the ratio may hide a firm's high current debt. Take care to look not only at the ratio but also how it was calculated.

Lack of Context for the Figures

The equation doesn't tell you how the ratio has changed over time. As a result, it fails to show whether a firm's ability to repay its debt is getting better or worse.

Nor does the equation tell you whether the ratio is competitive with that of others in the same industry. For instance, some industries may have a lower cash-flow-to-debt ratio than others. If you rely too much on the ratio, you may write off potentially sound investments.

On the flip side, you might invest in firms that have a ratio that is much lower than others in the same industry even if it is above 1. That's why it's important to compare apples to apples. Look at the cash flow-to-debt ratios of companies in the same industry. Take a holistic approach when evaluating a firm's financial statements.

Key Takeaways

  • The cash flow-to-debt ratio is a comparison of a firm's operating cash flow to its total debt.
  • You can calculate it if you divide the annual operating cash flow on the firm's cash flow statement by current and long-term debt on the balance sheet.
  • The ratio reflects a company's ability to repay its debts and within what time frame, and an optimal ratio is 1 or higher.
  • The ratio should be viewed in the context of comparable firms and alongside other financial statements.