Cash Flow Coverage Ratio
The cash flow coverage ratio is an indicator of the ability of a company to pay interest and principal amounts when they become due. This ratio tells the number of times the financial obligations of a company are covered by its earnings. A ratio equal to one or more than one means that the company is in good financial health and it can meet its financial obligations through the cash generated by operating activities. A ratio of less than one is an indicator of bankruptcy of the company within two years if it fails to improve its financial position.
It is an important indicator of the liquidity position of a company. This ratio is often used by the banks to decide whether to make or refinance any loan.
There are different formulas used for the calculation of this ratio. Some of the most commonly used formulas are given below.
Cash Flow Coverage Ratio = Operating Cash Flows / Total Debt
The figure for operating cash flows can be found in the statement of cash flows. Total debt includes the interest, short-term borrowings, current portion of long-term debt and long-term debt. This ratio shows the ability of a company to pay its debt from the cash it generates from its operations. A very low ratio can be an indication of too much debt or poor cash generation.
Another formula used for the calculation of cash flow coverage ratio is
Cash flow coverage ratio = (Net Earnings + Depreciation + Amortization) / Total Debt
This ratio also has some variations. For example, free cash flows can be used instead of operating cash flows. This will be a more conservative ratio which provides for the capital expenditure. Another variation may be used to include the payments for preferred dividends, non-cancelable financial lease payments, redeemable shares, and rental payments. This will be a more conservative ratio which takes into account more financial obligations.