
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 shortterm borrowings, the current portion of longterm debt and longterm 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 shortterm borrowings, current portion of longterm debt, longterm debt, redeemable preferred stock and twothirds of the principal of noncancelable 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 doubledigit 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 longterm debt and longterm 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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