What it means
Accounting profit is a poor guide for asset-heavy businesses because depreciation on a pipeline or a building can be enormous while the cash cost of keeping that asset working is much smaller. Distributable cash flow was built to bridge that gap and answer a simple question: how much can be paid out without eating into the business?
The calculation usually starts from adjusted earnings before interest, tax, depreciation and amortisation, then subtracts cash interest paid, cash taxes and maintenance capital expenditure. Growth capital spending is deliberately excluded, on the logic that expansion is optional and is often funded separately.
The measure is not defined by accounting standards, which is both its strength and its weakness. Management chooses the adjustments, so two similar businesses can present very different figures, and a careful reader always checks what has been added back.
The coverage ratio is where the number earns its keep. A ratio above 1.0 means the payout is funded from cash the business generated, while a ratio below 1.0 means part of the distribution is coming from borrowings, asset sales or new units issued to investors.
The classic warning sign is a company that classifies almost all its capital spending as growth. That flatters distributable cash flow today and leaves the asset base quietly deteriorating, which eventually forces a cut to the distribution that investors were relying on.
In practice
Real-world examples.
Example
A listed toll road operator reports distributable cash flow of $240,000,000 and a distribution of $200,000,000, giving coverage of 1.2 times. Management keeps the retained $40,000,000 as a buffer against a weak traffic year rather than raising the payout.
Example
A property trust cuts its quarterly distribution after coverage falls to 0.85 times for two consecutive quarters. The board judges that funding the shortfall from its credit facility is not sustainable, and the market rewards the early cut.
Example
An analyst comparing two pipeline partnerships notices that one deducts $60,000,000 of maintenance capital expenditure and the other only $12,000,000 on a similar asset base. She adjusts both to a consistent basis before comparing yields.
Think of it
“Distributable cash flow is the money available to actually pay out to investors.
Formula
Calculation
Distributable cash flow = Adjusted EBITDA - Cash interest - Cash taxes - Maintenance capital expenditure
Coverage ratio = Distributable cash flow / Distributions paid
A midstream energy partnership reports adjusted EBITDA of $180,000,000 for the year. It pays $32,000,000 of cash interest, $8,000,000 of cash taxes, and spends $25,000,000 on maintenance capital expenditure to keep its existing terminals in service.
Distributable cash flow = $180,000,000 - $32,000,000 - $8,000,000 - $25,000,000 = $115,000,000
The partnership distributes $92,000,000 to unitholders during the year.
Coverage ratio = $115,000,000 / $92,000,000 = 1.25 times
With 100,000,000 units outstanding, that is $115,000,000 / 100,000,000 = $1.15 of distributable cash flow per unit against a distribution of $92,000,000 / 100,000,000 = $0.92 per unit, leaving $0.23 per unit retained in the business.Case study
Seen in the real world.
Coldharbour Terminals is a fictional storage and logistics partnership created to illustrate how coverage ratios protect investors. For four years it reported distributable cash flow comfortably above its payout, with coverage between 1.2 and 1.3 times, and its units traded on a stable yield.
In the fifth year, adjusted EBITDA slipped from $180,000,000 to $150,000,000 after a major customer did not renew. Management held the distribution at $92,000,000, which pushed coverage to $85,000,000 / $92,000,000 = 0.92 times once interest, tax and maintenance spending were deducted, and the shortfall was funded from the revolving credit facility.
The board cut the distribution to $75,000,000 the following year, restoring coverage above 1.1 times, and units fell 18% on the announcement. The illustrative lesson is that coverage below 1.0 is a borrowed distribution, and borrowed distributions have a short life.
Watch out
Common mistakes.
- Treating distributable cash flow as a standardised accounting measure. It is not defined by accounting standards, so the adjustments differ between companies and must be read in the notes.
- Ignoring how maintenance and growth capital spending are split. Shifting spending into the growth bucket raises the reported figure without any change to the underlying business.
- Judging an investment on yield alone. A high yield with coverage below 1.0 is usually a distribution cut waiting to happen.
Questions
People also ask.
How is it different from free cash flow?
Free cash flow deducts all capital expenditure, while distributable cash flow deducts only maintenance spending and starts from an adjusted earnings figure.
What coverage ratio is healthy?
Many income vehicles target 1.1 to 1.3 times, which funds the payout while retaining a cushion for weak periods and small reinvestment.
Why do partnerships and trusts use it?
Their purpose is to pass cash to investors, so a cash-based measure of capacity to pay is more useful than accounting profit weighed down by depreciation.
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