This is a detailed guide on how to calculate Cash Flow Coverage Ratio with in-depth analysis, example, and interpretation. You will learn how to utilize this ratio’s formula to assess a firm's debt settlement ability.
Definition - What is Cash Flow Coverage Ratio?
Similar to the fixed charge coverage ratio, the cash flow coverage ratio is a simple calculation that you can use to assess a company’s ability to pay all of its interest and fixed expenses.
This ratio focuses primarily on the capacity of a firm's cash flow to cover all non-expense items, which contain payments for dividends, capital expenditures (CAPEX), and the principal on debt.
The CF coverage ratio is particularly useful when evaluating businesses that are quickly expanding their fixed assets bases or businesses with heavy debt burdens.
In this article, we’ll look into how to calculate this ratio and how to use it as a tool to measure a company’s debt repayment capacity.
In order to calculate the cash flow coverage ratio, we’ll simply sum all principal payments, dividend payments, and capital expenditures, and then divide the result by operating cash flow, as follows:
Cash Flow Coverage Ratio = (Total Debt Payments + Dividend Payments + CAPEX) / Operating Cash Flow
You can easily find the operating cash flow reported on a company’s cash flow statement. It’s also known as cash flow from operating activities.
Capital expenditure, or CAPEX, can be easily found on the cash flow statement as well. It's usually referred to as Sale of Property, Plant, and Equipment.
Okay now let's consider a quick example so you can clearly understand how to compute the CFC ratio.
Assume that you’d like to evaluate Company E to see if it has enough cash flow to cover its capital expenditures and debt payments for the upcoming year.
Looking into this company’s cash flow statement, you discover the following information:
- Sale of Property, Plant, and Equipment = $65,000
- Total Principal Payments = $40,000
- Cash Dividends Paid = $7,000
- Cash Flow from Operating Activities = $200,000
By using the provided formula, you can calculate the CFC ratio as follows:
The cash flow coverage ratio of 0.875 indicates that Company E can generate enough cash to meet its non-expense payments, including interest charges, CAPEX, and dividend payments.
Interpretation & Analysis
Okay now we're done with the calculation, let's dive into how to use this ratio to measure a firm's solvency.
The ratio equal or less than 1.0 tells us that the company is financially healthy and it’s generating enough cash to cover or meet its debt payments when due.
The ratio of greater than 1.0 is a sure sign that the company is not able to cover its current interest and non-expense payments, possibly resulting in bankruptcy in the near future.
So what is a good cash flow coverage ratio?
Ideally speaking, when evaluating a firm’s debt repayment capacity, you’ll want the cash flow coverage ratio to be less than 1.0. In short, the lower the ratio, the better.
Cautions & Further Explanation
The result of using this ratio may be misleading in cases where a business has an upcoming or ongoing principal payment on its debt.
That's because the measure does not indicate the future principal payment requirements, or in other words, it's typically historical in nature.
The similar problem may also arise in the case of capital expenditures since the historical pattern of expenditures may not resemble upcoming CAPEX requirements.
However, these issues can be easily resolved by calculating the measurement on a forward-looking basis.