What it means
Leverage is usually measured against profit (debt to EBITDA) or against equity (debt to equity), but debt is repaid from neither. It is repaid from cash.
Cash flow to debt puts the obligation against the actual resource, and its inverse, debt to cash flow, is the number of years of cash generation the borrowings represent. The numerator is operating cash flow, taken from the cash flow statement: cash from operations after working capital movements, tax and (in most presentations) interest.
Some analysts use funds from operations (before working capital movements, to remove the year-to-year swing); rating agencies typically use this variant, called FFO to debt. Others use free cash flow (after capital expenditure), which asks how much could go to debt after the business has maintained itself; this retained cash flow measure is the most conservative.
The denominator is total interest-bearing debt: loans, bonds, overdrafts, and lease liabilities under current standards, sometimes net of cash, and sometimes adjusted for pension deficits and other debt-like items. Thresholds depend on the industry and the stability of cash flows.
Rating agencies publish guidance: for industrial companies, FFO to debt above about 45% is consistent with high investment-grade ratings, 20% to 30% with the lower investment grades, below 12% with speculative grades; for regulated utilities with stable cash flows the bands are lower; for cyclical companies higher. Lenders set covenant floors, often 15% to 20% on operating cash flow to debt, tested annually.
The ratio is read with its trend and with the maturity profile. A ratio of 20% is comfortable if the debt is spread over ten years and uncomfortable if half of it falls due next year.
A falling ratio, because debt is growing faster than cash flow, is the classic pre-distress pattern, visible several years ahead. Combined with interest cover and debt service coverage, it gives a full picture: can the company pay interest (interest cover), can it meet this year's principal and interest (debt service coverage), and how long would it take to clear the whole debt (cash flow to debt).
Management uses the ratio in setting financial policy (a target ratio that defines how much the company will borrow), in evaluating debt-funded acquisitions and investments (what ratio the deal leaves and how quickly it recovers), and in communicating with lenders and rating agencies. A policy such as "operating cash flow to net debt above 30% through the cycle" is a statement of the leverage the board considers prudent, and departures from it are decisions the board should make explicitly.
In practice
Real-world examples.
Example
A telecoms company with operating cash flow of $2 billion and debt of $12 billion (17%) is rated at the lowest investment grade and told that a ratio below 15% would mean a downgrade.
Example
A software company with operating cash flow of $300 million and debt of $200 million (150%) could repay its debt in eight months and carries it only for the tax benefit.
Example
A retailer's ratio falls from 30% to 9% over five years of debt-funded expansion, and its bonds trade at distressed prices before it restructures.
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%
Debt to Cash Flow (years) = Total debt / Operating cash flow
FFO to Debt = Funds from operations (operating cash flow before working capital movements) / Total debt
Retained Cash Flow to Debt = (Operating cash flow minus Capex minus Dividends) / Total debt
Worked example. A building products manufacturer: operating cash flow $36,000,000; funds from operations (before a $5,000,000 working capital absorption) $41,000,000; capital expenditure $14,000,000; dividends $8,000,000; bank loans $80,000,000; bonds $60,000,000; lease liabilities $25,000,000; cash $15,000,000.
- Total debt = $165,000,000; net debt = $150,000,000
- Cash flow to debt = $36,000,000 / $165,000,000 = 21.8%; years to repay = 4.6
- Cash flow to net debt = $36,000,000 / $150,000,000 = 24.0%
- FFO to debt = $41,000,000 / $165,000,000 = 24.8% (the rating agency's measure; its guidance for the company's current rating is 20% to 30%)
- Retained cash flow to debt = ($36,000,000 minus $14,000,000 minus $8,000,000) / $165,000,000 = $14,000,000 / $165,000,000 = 8.5%: after maintaining the business and paying the dividend, the company retains enough to repay about 8.5% of its debt a year, or 12 years to clear it
Trend: three years ago operating cash flow was $34,000,000 and total debt $120,000,000: ratio 28.3%. Debt has risen $45,000,000 (an acquisition and the recognition of leases) while cash flow has risen $2,000,000. The ratio has fallen 6.5 points; the rating agency has placed the company on negative outlook.
Proposed transaction: a $40,000,000 debt-funded acquisition adding $6,000,000 of operating cash flow. Post-deal: $42,000,000 / $205,000,000 = 20.5%, at the bottom of the rating band; FFO to debt about 23%. The board decides to fund $15,000,000 of the price with a share placing, giving $42,000,000 / $190,000,000 = 22.1%, and to suspend the buyback programme until the ratio returns above 25%, which the projections show in two years as the acquired business's cash flow builds and $20,000,000 of debt is repaid.
Downside: a 20% fall in operating cash flow to $33,600,000 post-deal gives a ratio of 17.7%, below the 20% rating threshold and close to the bank covenant of 15%. The board notes the exposure and makes the placing a condition of the deal.Case study
Seen in the real world.
A hotel group had grown by acquiring properties with bank debt, and its board tracked net debt to EBITDA, which stood at 4.5 times, within the covenant of 5.0. Its chief financial officer began reporting operating cash flow to debt alongside it after a lender asked for the figure. It was 11%: EBITDA of $90 million was producing operating cash flow of only $48 million because of working capital absorbed by new hotels, tax, and interest at $30 million, and debt stood at $430 million.
Nine years of cash flow to repay, before any capex. The board had believed, from the EBITDA measure, that the group was moderately leveraged; the cash measure said it was highly leveraged.
A second lender declined to refinance a facility, and the group sold two hotels to bring the ratio to 16%, suspended acquisitions, and adopted a policy of operating cash flow to debt above 20% before any further borrowing. The chief financial officer's board paper explained that EBITDA to debt had measured leverage against an accounting construct that excluded the interest and tax the debt itself created, and that cash flow to debt measured it against the money.
Watch out
Common mistakes.
- Measuring leverage only against EBITDA, which excludes interest, tax and working capital, and can show moderate leverage when cash flow to debt shows high leverage.
- Excluding lease liabilities from debt when comparing with peers or rating agency thresholds that include them.
- Reading the ratio without the maturity profile. Ten years of cash flow to repay is manageable if nothing falls due soon and dangerous if it does.
Questions
People also ask.
What is a good cash flow to debt ratio?
Above 40% is strong; 20% to 30% is adequate for stable businesses; below 15% is weak for most industries. Thresholds vary by sector and cash flow stability.
What is the difference between cash flow to debt and debt service coverage?
Cash flow to debt compares cash with the whole debt (how long to repay). Debt service coverage compares cash with this year's interest and principal (can this year's payments be met).
Should operating cash flow or free cash flow be used?
Operating cash flow is standard and comparable with published thresholds. Free (or retained) cash flow is a stricter test that shows what could really go to debt after maintaining the business and paying dividends.
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