1. Cash Flow Indicator Ratios: Introduction
  2. Cash Flow Indicator Ratios: Operating Cash Flow/Sales Ratio
  3. Cash Flow Indicator Ratios: Free Cash Flow/Operating Cash Flow Ratio
  4. Cash Flow Indicator Ratios: Cash Flow Coverage Ratios
  5. Cash Flow Indicator Ratios: Dividend Payout Ratio

By Richard Loth (Contact | Biography)

This ratio measures the ability of the company's operating cash flow to meet its obligations - including its liabilities or ongoing concern costs.

The operating cash flow is simply the amount of cash generated by the company from its main operations, which are used to keep the business funded.


The larger the operating cash flow coverage for these items, the greater the company's ability to meet its obligations, along with giving the company more cash flow to expand its business, withstand hard times, and not be burdened by debt servicing and the restrictions typically included in credit agreements.

Formulas:





Components:




As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had no short-term debt and did not pay any cash dividends. The only cash outlay the company had to cover was for capital expenditures, which amounted to $255.3 (all numbers for the cash flow coverage ratios are found in the cash flow statement), which is the denominator. Operating cash is always the numerator. By dividing, the operative equations give us a coverage of 3.4. Obviously, Zimmer is a cash cow. It has ample free cash flow which, if the FY 2003-2005 period is indicative, has steadily built up the cash it carries in its balance sheet.

Variations:
None

Commentary:
The short-term debt coverage ratio compares the sum of a company's short-term borrowings and the current portion of its long-term debt to operating cash flow. Zimmer Holdings has the good fortune of having none of the former and only a nominal amount of the latter in its FY 2005 balance sheet. So, in this instance, the ratio is not meaningful in the conventional sense but clearly indicates that the company need not worry about short-term debt servicing in 2006.

The capital expenditure coverage ratio compares a company's outlays for its property, plant and equipment (PP&E) to operating cash flow. In the case of Zimmer Holdings, as mentioned above, it has ample margin to fund the acquisition of needed capital assets. For most analysts and investors, a positive difference between operating cash flow and capital expenditures defines free cash flow. Therefore, the larger this ratio is, the more cash assets a company has to work with.

The dividend coverage ratio provides dividend investors with a narrow look at the safety of the company's dividend payment. Zimmer is not paying a dividend, although with its cash buildup and cash generation capacity, it certainly looks like it could easily become a dividend payer.

For conservative investors focused on cash flow coverage, comparing the sum of a company's capital expenditures and cash dividends to its operating cash flow is a stringent measurement that puts cash flow to the ultimate test. If a company is able to cover both of these outlays of funds from internal sources and still have cash left over, it is producing what might be called "free cash flow on steroids". This circumstance is a highly favorable investment quality.

Cash Flow Indicator Ratios: Dividend Payout Ratio

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