Formula

Cash Flow to Debt Ratio = Operating Cash Flow/Total Debt

Meaning

The cash flow to debt ratio tells investors how much cash flow the company generated from its regular operating activities compared to the total debt it has. For instance if the ratio is 0.25, then the operating cash flow was one fourth of the total debt the company has on its books. This debt includes interest payments, principal payments and even lease payments to cover off balance sheet financing.

Assumptions

• Does Not Cover Amortization: The cash flow to debt ratio assumes interest and principle payments will be paid in the same manner over the years as they have been paid in this year. This assumption is implicit in the fact that while calculating total debt (denominator) we take the interest and principal payments from the present year financial statements.

  However, this may not be the case. Companies have access to a variety of financing schemes. Some of these schemes include interest only payments, bullet payments, balloon payments, negative amortization, so on and so forth. In such innovative amortization, there may be years when the company has to pay a lot of interest and other years when it has to pay none. Hence the present years figures may not be indicative of the future.

• Does Not Cover Lease Increment: Once again, the ratio takes the lease numbers from the financial statements of the current year. However, most lease contracts nowadays have lease increment provisions in them. This means that every year the lease may go up by a certain percentage. The ratio does not cover this aspect.

Interpretation

• Creditworthiness: Cash flow to debt ratio is the true measure of the creditworthiness of a firm. This is because a company has to pay its interest and retire its debt by paying cash. They cannot pass on the earnings that they may have recorded on accrual basis to creditors to satisfy their claims.

  Earlier analysis used earnings because at that time credit periods were small or nonexistent and therefore earnings to some extent meant cash flow. However, with the proliferation of credit, the distinction has been widened.

  A company may book earnings immediately and not receive cash for years on end. Thus creditors have their eyes set on cash flow ratios.

• Analysis of the Past: The cash flow to debt ratio thus becomes an analysis of how comfortably the company paid its obligations in the past. The future may or may not be similar. Analysts have to make adjustments to this ratio to make it more meaningful.