Things to Know About Cash Flow to Debt Ratio

Apr 22, 2022 By Susan Kelly

The cash flow ratio to debt is a ratio that measures the amount of cash generated by a company against its debt total. The primary cash flow utilized to calculate that ratio will be cash flow generated by operations, but the use of free cash flow that is unlevered can be a viable alternative. Some companies may choose to utilize their EBITDA number to calculate. But, this isn't advised, as EBITDA is a way of calculating the purchase of new inventory that could take a long time to be sold and thus generate cash flow.


Although it's not realistic for a business to commit all its cash flow to the repayment of debts, the ratio of cash flow to debt gives a picture of the overall financial condition of a business. A high ratio indicates that a business is better in its ability to repay its debts and thus can take on more loans if needed.

Another method of calculating the cash flow ratio to debt is to examine the company's EBITDA instead of the operating cash flows. This method is not used as often since it incorporates investment in inventory and because inventory cannot be sold as quickly, so it's not as liquid as cash flow from operations. Without more information about the company's assets, it's difficult to know if an organization can cover its debt obligations with an EBITDA method.

How Do You Calculate the Cash Flow-to-Debt Ratio?

To determine a company's cash flow ratio to debt, it is first necessary to calculate the year-long operating cash flow. The operating cash flow can be defined as earnings before tax and interest (EBIT), depreciation, and fewer taxes. The EBIT represents the net annual income, interest expense, and tax-related income. After that, add up the short- and long-term obligations to calculate your total amount of debt. Then split the cash flow for operating with the debt total to calculate the ratio of cash flow to debt.

Free Cash Flow and Cash Flow from Operations

Certain analysts employ the free flow of cash instead of cash flow from operations because the measure subtracts cash used to finance capital expenditures. The use of Free Cash Flow instead of cash flow from operations might suggest that the business is not capable of meeting its obligations. The cash flow ratio to debt examines the relationship between cash flow and total debt. Analysts may also look at how much cash flows only to long-term debt. This can offer a more positive image of the financial health of a business when the company has taken on substantial short-term debt. When looking at the ratios, it is essential to note that they differ widely across different industries. An appropriate analysis should be able to examine these ratios in comparison to others in the same sector.


Diverse Methods of Calculation

The variables utilized to calculate the ratio do not have to be fixed in stones. For example, if an analyst employs operational cash flow in lieu of free, the calculation does not include working capital and capital expenditure. These could be huge for companies that are growing. If the only long-term debt is incorporated in the debt calculation, this ratio could conceal the company's current high debt. Make sure you examine the ratio and how it was determined.

Lack of Context for the Figures

The formula doesn't reveal the changes in ratio have been over time. It isn't able to tell the extent to which a company's ability to pay back its debt is becoming more or less. It also doesn't determine if the ratio is comparable to other companies in the same sector. For example, certain sectors may have lower cash flow ratios to debt than other industries. If you place too much emphasis on this ratio, you could eliminate potentially safe investments.

It is possible to decide to invest in a business with an X ratio less than other firms in the same field; however, it may be higher than 1. This is why it's crucial to evaluate apples against apples. Take a look at businesses' cash flow to debt ratios within the same industry. Use a holistic approach when looking at a company's financial statements.

Other Considerations

In calculating the cash flow ratio to debt, analysts don't typically make use of money flow from finance or the cash flowing from investment. If the company has a highly leveraged capital structure, the company likely has an amount of debt to pay. It's not sensible to conclude that the business was paying down its debt with its debt capital. Thus the cash flow from financing is not included in calculating the ratio. The cash flow generated by investments is not often included when calculating the ratio, as investments are not an element of the company's principal cash-generating activities. It is recommended to select the cash flow figure that more accurately represents the company's daily activities. Two choices include cash flow from operations and non-levered cash flow.

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