If you were considering buying stock in a company, but you were worried that it was taking on more debt than it could handle, you could calculate the cash flow-to-debt ratio. That would allow you to see how the company’s operating cash flow measures up to its overall liabilities.
How Do You Calculate the Cash Flow-to-Debt Ratio?
To calculate a company’s cash flow-to-debt ratio, first figure out its annual operating cash flow. This is one of the three cash flows listed on the cash flow statement. Operating cash flow is calculated as earnings before interest and taxes (EBIT), plus depreciation, minus taxes. The EBIT itself amounts to the net annual income, plus interest expenses, plus income tax expenses. Next, add up current and long-term liabilities (shown on the firm’s balance sheet) to figure the total debt. Last, divide the operating cash flow by the total debt to obtain the cash flow-to-debt ratio.
How the Cash Flow-to-Debt Ratio Works
The ratio tells you two things about a company:
Its capacity to repay its debts: The higher the ratio, the more able a firm is to pay off debts.The length of time needed to repay its debts: Dividing 1 by the cash flow-to-debt ratio tells you how many years it will take to pay off its total debt.
A ratio of 1 or greater is best, whereas a ratio of less than 1 shows that a firm isn’t generating sufficient cash flow—and doesn’t have the liquidity—to meet its debt obligations. This is key, as a firm that may not be able to pay its debts is headed for trouble and may not be a stock you want to own. For instance, suppose that ABC Corp. has an operating cash flow of $5 billion but has $20 billion in total debt. It has a cash flow-to-debt ratio of 0.25, which means that it would take a whopping four years to pay off its debt (1 divided by 0.25). XYZ Corp., in contrast, has an operating cash flow of $20 billion and is only $16 billion in debt. Its cash flow-to-debt ratio is a more solid 1.25. It can repay its debt in less than 10 months. It may even be able to pay down its debt sooner through larger payments, or it could take on more debt and expand.
Limitations of the Cash Flow-to-Debt Ratio
The ratio has two key constraints: diverse methods of calculation and lack of context for the figures.
Diverse Methods of Calculation
The variables that are used to figure out the ratio are not set in stone. If an analyst uses free cash flow instead of operating cash flow, for instance, the calculation excludes working capital and capital spending. These may be substantial for a growing company. Likewise, if only long-term debt is factored into the debt calculation, the ratio may hide a firm’s high current debt. Take care to look not only at the ratio but also how it was calculated.
Lack of Context for the Figures
The equation doesn’t tell you how the ratio has changed over time. As a result, it fails to show whether a firm’s ability to repay its debt is getting better or worse. Nor does the equation tell you whether the ratio is competitive with those of others in the same industry. For instance, some industries may have a lower cash-flow-to-debt ratio than others. If you rely too much on the ratio, you may write off potentially sound investments. You might invest in a firm that has a ratio that is much lower than those of others in the same industry, even if it is above 1. That’s why it’s important to compare apples to apples. Look at the cash flow-to-debt ratios of companies in the same industry. Take a holistic approach when evaluating a firm’s financial statements.
