What it means
Lenders worry less about how large a company's debt is than about whether it can repay it. Cash flow to debt answers that by putting annual cash generation next to the debt balance.
A result of 25% means that one year of operating cash flow would repay a quarter of the debt. The inverse is also helpful.
Dividing debt by cash flow shows roughly how many years it would take to repay all borrowing if every dollar of cash went to debt. A company with a ratio of 25% would need about four years.
The ratio belongs to the same family as the cash flow coverage ratio, and the two names are often used interchangeably. Some analysts prefer a version using free cash flow, which deducts capital spending, or one that uses net debt, which subtracts the cash the company already holds.
The label matters less than a clear definition. Rating agencies and bankers use cash flow to debt when setting credit ratings and loan terms.
Companies with high ratios can usually borrow at lower interest rates and with fewer restrictions. A falling ratio over several years can lead to a downgrade or tighter covenants.
Context is essential. A business with predictable income can safely carry a lower ratio than one with cyclical income.
Seasonal firms should use a full-year figure, and analysts should adjust for one-off items that distort cash flow. Companies can use the ratio as an internal target.
A board might set a policy that cash flow to debt should stay above 20%, and that new borrowing is allowed only if the ratio will remain above that level after the project. Such a rule gives managers a clear limit and gives lenders confidence.
In practice
Real-world examples
Example 1
A food distributor has cash flow of $900,000 and debt of $3,000,000, a ratio of 30%. The bank is comfortable offering a new facility. The distributor negotiates a lower interest margin. The distributor uses some of the headroom to buy new delivery vehicles, while keeping the ratio above 25%.
Example 2
A shipping firm has cash flow of $400,000 and debt of $8,000,000, a ratio of 5%. It would take 20 years to repay the debt from cash flow alone. A rating agency places it on a negative outlook. Management is told to cut costs and sell non-core assets to restore the ratio before the next review.
Example 3
A pharmaceutical company with cash flow of $5,000,000 and debt of $10,000,000 plans an acquisition funded by another $5,000,000 of borrowing. The ratio would fall from 50% to 33%. The board decides this is acceptable because the target is expected to add cash flow.
Think of it
Cash flow to debt shows what portion of your total debt you could pay off each year from cash generated.
Formula
Calculation
Cash flow to debt = Operating cash flow / Total debt x 100
Worked example: a company has operating cash flow of $1,500,000 and total debt of $6,000,000. It also holds $1,500,000 in cash.
Step 1: Divide: $1,500,000 / $6,000,000 = 0.25, or 25%.
Step 2: Years to repay = $6,000,000 / $1,500,000 = 4 years.
On a net debt basis, net debt = $6,000,000 - $1,500,000 = $4,500,000, and the ratio is $1,500,000 / $4,500,000 = 33.3%.Case study
Seen in the real world
Eastgate Packaging is an illustrative, fictional manufacturer with operating cash flow of $2,000,000 and debt of $10,000,000, a ratio of 20%. The company's bank had set a covenant requiring at least 15%. A downturn cut cash flow to $1,200,000.
The ratio fell to 12%, below the covenant. The finance director had warned the bank at the first sign of trouble and presented a plan to sell a spare warehouse for $3,000,000 and repay debt. The ratio would then be $1,200,000 / $7,000,000 = 17%.
The bank accepted the plan. The illustrative lesson is that this ratio can be improved from both sides: by raising cash flow or by reducing debt. From then on, the board set a minimum ratio in its borrowing policy, and tested every large project against it before approval.
Watch out
Common mistakes
- Using profit instead of operating cash flow, so the ratio ignores timing and non-cash items.
- Comparing ratios that define debt differently, such as including or excluding leases.
- Assuming a low ratio always means danger, when stable, asset-rich businesses can carry more debt.
Questions
People also ask
Is cash flow to debt the same as the cash flow coverage ratio?
In most cases yes, they use the same inputs, although some analysts use variations such as free cash flow or net debt.
What is a healthy level?
It varies by industry, but lenders often prefer 20% or higher, and rating agencies set their own bands. A trend of improvement is often as important to lenders as the level itself.
How can a company improve it?
By raising operating cash flow through better collections and margins, or by reducing debt through repayments or asset sales.