Debt Ratios: Cash Flow To Debt Ratio
AAA
  1. Debt Ratios: Introduction
  2. Debt Ratios: Overview Of Debt
  3. Debt Ratios: The Debt Ratio
  4. Debt Ratios: Debt-Equity Ratio
  5. Debt Ratios: Capitalization Ratio
  6. Debt Ratios: Interest Coverage Ratio
  7. Debt Ratios: Cash Flow To Debt Ratio
Debt Ratios: Cash Flow To Debt Ratio

Debt Ratios: Cash Flow To Debt Ratio

By Richard Loth (Contact | Biography)

This coverage ratio compares a company's operating cash flow to its total debt, which, for purposes of this ratio, is defined as the sum of short-term borrowings, the current portion of long-term debt and long-term debt. This ratio provides an indication of a company's ability to cover total debt with its yearly cash flow from operations. The higher the percentage ratio, the better the company's ability to carry its total debt.

Formula:


Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had net cash provided by operating activities (operating cash flow as recorded in the statement of cash flows) of $878.20 (cash flow statement), and total debt of only $1,036.80 (balance sheet). By dividing, the equation provides the company, in the Zimmer example, with a cash flow to debt ratio of about 85%.

Variations:
A more conservative cash flow figure calculation in the numerator would use a company's free cash flow (operating cash flow minus the amount of cash used for capital expenditures).

A more conservative total debt figure would include, in addition to short-term borrowings, current portion of long-term debt, long-term debt, redeemable preferred stock and two-thirds of the principal of non-cancel-able operating leases.

Commentary:
In the case of Zimmer Holdings, their debt load is higher than their operating cash flows, giving it a ratio of less than one, however the percentage (being above 80%) is considered high. In this instance, this circumstance would indicate that the company has ample capacity to cover it's debt expenses with its operating cash flow.

Under more typical circumstances, a high double-digit percentage ratio would be a sign of financial strength, while a low percentage ratio could be a negative sign that indicates too much debt or weak cash flow generation. It is important to investigate the larger factor behind a low ratio. To do this, compare the company's current cash flow to debt ratio to its historic level in order to parse out trends or warning signs.

More cash flow to debt relationships are evidenced in the financial positions of IBM and Merck, which we'll use to illustrate this point. In the case of IBM, its FY 2005 operating cash amounted to $14.9 billion and its total debt, consisting of short/current long-term debt and long-term debt was $22.6 billion. Thus, IBM had a cash flow to debt ratio of 66%. Merck's numbers for FY 2005 were $7.6 billion for operating cash flow and $8.1 billion for total debt, resulting in a cash flow to debt ratio of 94%.

If we refer back to the Capitalization Ratio page, we will see that Merck had a relatively low level of leverage compared to its capital base. Thus, it is not surprising that its cash flow to debt ratio is very high.

Proceed to the next chapter on Operating Performance Ratios here.
Or, click here to return to the Financial Ratio Tutorial main menu.


  1. Debt Ratios: Introduction
  2. Debt Ratios: Overview Of Debt
  3. Debt Ratios: The Debt Ratio
  4. Debt Ratios: Debt-Equity Ratio
  5. Debt Ratios: Capitalization Ratio
  6. Debt Ratios: Interest Coverage Ratio
  7. Debt Ratios: Cash Flow To Debt Ratio
Debt Ratios: Cash Flow To Debt Ratio
RELATED TERMS
  1. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  2. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  3. Working Capital

    This ratio indicates whether a company has enough short term ...
  4. Bid Wanted

    An announcement by an investor who holds a security that he or ...
  5. Net Present Value - NPV

    The difference between the present value of cash inflows and ...
  6. Total Debt-to-Capitalization Ratio

    An indicator that measures the total amount of debt in a company’s ...
  1. Why do share prices fall after a company has a secondary offering?

    The best way to answer this question is to provide a simple illustration of what happens when a company increases the number ...
  2. What are the generally accepted accounting principles for inventory reserves?

    As with most matters related to generally accepted accounting principles (GAAP), accountants assigned with the task of applying ...
  3. Why is the compound annual growth rate (CAGR) misleading when assessing long-term ...

    The compound annual growth rate (CAGR) measures the return on an investment over a certain period of time. Below is an overview ...
  4. How do I take qualitative factors into consideration when using fundamental analysis?

    Fundamental analysis is the method of analyzing companies based on factors that affect their intrinsic value. There are two ...
comments powered by Disqus
Related Tutorials
  1. Investing For Safety and Income Tutorial
    Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  2. Discounted Cash Flow Analysis
    Fundamental Analysis

    Discounted Cash Flow Analysis

  3. Ratio Analysis Tutorial
    Fundamental Analysis

    Ratio Analysis Tutorial

  4. American Depositary Receipt Basics
    Economics

    American Depositary Receipt Basics

  5. Stock Basics Tutorial
    Investing Basics

    Stock Basics Tutorial

Trading Center