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

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.
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