Cash flow to debt ratio

The cash flow to debt ratio reveals the ability of a business to support its debt obligations from its operating cash flows. This is a type of debt coverage ratio. A higher percentage indicates that a business is more likely to be able to support its existing debt load. The calculation is to divide operating cash flows by the total amount of debt. The total amount of debt includes short-term debt, the current portion of long-term debt, and long-term debt. The formula is:

Operating cash flows ÷ Total debt 

For example, a business has a sum total of $2,000,000 of debt. Its operating cash flow for the past year was $400,000. Therefore, its cash flow to debt ratio is calculated as:

$400,000 operating cash flows ÷ $2,000,000 total debt = 20%

The 20% outcome indicates that it would take the organization five years to pay off the debt, assuming that cash flows continue at the current level for the next five years.

An issue with this ratio is that it does not consider how soon the debt matures. If the maturity date is in the immediate future, then it is entirely possible that a firm will not be able to pay off its debt, despite a robust cash flow to debt ratio.

A variation on this ratio is to use free cash flow instead of cash flow from operations in the ratio. Free cash flow subtracts cash expenditures for ongoing capital expenditures, which can substantially reduce the amount of cash available to pay off debt.