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 through an example, how to interpret it as an investor, and its limitations.

What Is 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 determine its annual operating cash flow, which is one of the three cash flows listed on the cash flow statement. Operating cash flow is typically 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 company'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 investors two things about a company:

  • Its capacity to repay its debts: The higher the ratio, the more capable a company is of paying off debts given its operating cash flow. A ratio of 1 or greater is optimal, whereas a ratio of less than 1 indicates that a firm isn't generating sufficient cash flow—and doesn't have the liquidity—to meet its debt obligations. This is an important consideration, as a company that may have difficulty paying its debts is headed for trouble and may not be a stock you want to own.
  • 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.

For example, 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, making its cash flow-to-debt ratio a more impressive 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 take on more debt and thereby expand the company in ways that make it more attractive to consumers and investors alike.

Especially in difficult economic times, cash flow can suffer, preventing debt repayment or a decrease in total debt. The larger the cash flow-to-debt ratio, the better a company can weather rough economic conditions.

Limitations of the Cash Flow-to-Debt Ratio

The ratio has two key constraints:

  • Diverse methods of calculation: The variables included in the equation used to calculate the ratio are not necessarily set in stone. If an analyst uses free cash flow instead of operating cash flow, for example, the calculation excludes working capital and capital spending, which may be substantial for a growing company. Likewise, if only long-term debt is factored into the debt calculation, the ratio may hide a company'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 give you an indication of how the ratio has changed over time and whether a firm's ability to repay its debt is improving or worsening. Nor does it tell you whether the ratio is competitive with that of others in the same industry. For example, some industries may have a lower cash-flow-to-debt ratio than other industries, so investors who rely too heavily on the ratio may write off potentially sound investments in a given industry as having an inadequate ratio. 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 do an apples-to-apples comparison of the cash flow-to-debt ratios of companies in the same industry and take a holistic approach when evaluating a company'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 may be calculated using non-standard variables and doesn't account for other industry-specific characteristics that impact the resulting figure, so it should be viewed in the context of comparable companies and alongside other financial statements.