What Is the Cash Flow-to-Debt Ratio?

The cash flow-to-debt ratio is the ratio of a company’s cash flow from operations to its total debt. This ratio is a type of coverage ratio and can be used to determine how long it would take a company to repay its debt if it devoted all of its cash flow to debt repayment. Cash flow is used rather than earnings because cash flow provides a better estimate of a company’s ability to pay its obligations.

The Formula for the Cash Flow-to-Debt Ratio 

Cash Flow to Debt=Cash Flow from OperationsTotal Debt\begin{aligned} &\text{Cash Flow to Debt} = \frac{ \text{Cash Flow from Operations} }{ \text{Total Debt} } \\ \end{aligned}Cash Flow to Debt=Total DebtCash Flow from Operations

The ratio is less frequently calculated using EBITDA or free cash flow.

What Does the Cash Flow-to-Debt Ratio Tell You?

While it is unrealistic for a company to devote all of its cash flow from operations to debt repayment, the cash flow-to-debt ratio provides a snapshot of the overall financial health of a company. A high ratio indicates that a company is better able to pay back its debt, and is thus able to take on more debt if necessary.

Another way to calculate the cash flow-to-debt ratio is to look at a company’s EBITDA rather than the cash flow from operations. This option is used less often because it includes investment in inventory, and since inventory may not be sold quickly, it is not considered as liquid as cash from operations.

Without further information about the make-up of a company’s assets, it is difficult to determine whether a company is as readily able to cover its debt obligations using the EBITDA method.

Free Cash Flow Instead of Cash Flow From Operations

Some analysts use free cash flow instead of cash flow from operations because this measure subtracts cash used for capital expenditures. Using free cash flow instead of cash flow from operations may, therefore, indicate that the company is less able to meet its obligations.

The cash flow-to-debt ratio examines the ratio of cash flow to total debt. Analysts sometimes also examine the ratio of cash flow to just long-term debt. This ratio may provide a more favorable picture of a company's financial health if it has taken on significant short-term debt. In examining either of these ratios, it is important to remember that they vary widely across industries. A proper analysis should compare these ratios with those of other companies in the same industry.

Key Takeaways

  • The cash flow-to-debt ratio compares a company's generated cash flow from operations to its total debt.
  • The cash flow-to-debt ratio indicates how much time it would take a company to pay off all of its debt if it used all of its operating cash flow for debt repayment (although this is a very unrealistic scenario).

Example of How to Use the Cash Flow to Debt Ratio

Assume that ABC Widgets, Inc. has total debt of $1,250,000 and cash flow from operations for the year of $312,500. Calculate the company's cash flow to debt ratio as follows:

Cash Flow to Debt=$312,500$1,250,000=.25=25%\begin{aligned} &\text{Cash Flow to Debt} = \frac{ \$312,500 }{ \$1,250,000 } = .25 = 25\% \\ \end{aligned}Cash Flow to Debt=$1,250,000$312,500=.25=25%

The company's ratio result of 25% indicates that, assuming it has stable, constant cash flows, it would take approximately four years to repay its debt since it would be able to repay 25% each year. Dividing the number 1 by the ratio result (1 / .25 = 4) confirms that it would take four years to repay the company's debt.

If the company had a higher ratio result, with its cash flow from operations higher relative to its total debt, this would indicate a financially stronger business that could increase the dollar amount of its debt repayments if needed.