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Get To Know Your Cash Flow-to-Debt Ratio Before Panicking About Debt

By Cassidi Heltcel, CPA

As of this writing, times are currently very tough for small businesses across the United States and all over the world. Among other world events, the lockdowns connected to COVID-19 have primarily created one of the worst global recessions in recent history.If you’re reading this, chances are that your business has weathered the worst part of the storm. It’s also likely that you have accumulated a substantial amount of debt in the process, and want to know if a rebound is possible. 

The answer lies in the cash flow-to-debt ratio. By measuring how much cash is coming in against the total level of debt, you can figure out how long it will take for the business to repay its debts. All you need are some financial statements, like the latest balance sheet and company cash flow statement, and this article will show you the rest.  

Determine debt coverage ability with the cash flow-to-debt ratio

The cash to debt ratio is the ratio of a company’s operating cash flow from operating activities to its total debt (including the portion of long term debt). 

To calculate the ratio, conduct the following calculation: 

Cash Flow to Debt Ratio Formula = Cash Flow from Operations / Total Debt

Also known as a coverage ratio, the cash flow-to-debt ratio is used to determine the debt service capacity of a business if it was to devote all of its cash towards paying off its debt. 

Example of how to use the cash flow-to-debt ratio

Assuming that Cool Company Co. has a total debt of $1,000,000 and cash flow from operations is $200,000, the company's cash flow to debt ratio is calculated as follows:

Cash Flow to Debt = $200,000/$1,000,000 = 0.20 = 20%

A 20% cash flow-to-debt ratio would mean that 20% of debt would be paid down each year if all cash was devoted to its repayment. Accordingly, at that rate, the entire debt will be completely paid off within 5 years.

Using EBITDA to calculate the cash flow-to-debt ratio

An alternative way to calculate the cash flow-to-debt ratio is to use a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA). Depending on the business, this option tends to be less popular, because not all inventory can be quickly sold in order to be diverted towards debt repayment.

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Cash flow from operations is the preferred method, due to the liquidity of cash flow. Using the EBITDA method requires investigation into the details of a company’s assets, the ability to liquidate them, and the length of time required.

Free Cash Flow vs. Cash Flow From Operations

The use of free cash flow vs. cash flow from operations is a stricter measure. Free cash flow subtracts cash used for capital expenditures, resulting in a lower amount of cash available and further indication that the company is less capable of paying its liabilities. 

A comparison of both these ratios should take into account that they vary widely across industries. A thorough analysis requires a comprehensive comparison of your business with similar companies in the same industry.

Strategies to repay debts faster

The task to calculate debt is straightforward and does not change. The only other option for repaying debt faster (other than debt restructuring) is to increase cash flow from operations. More often than not, business owners under stress fail to see opportunities in front of them for bringing in more cash, which include:

  • Marketing promotions

  • Setting higher sales goals

  • Increasing prices

  • Improving accounts receivable turnover

  • Improving inventory turnover

  • Cutting expenses

  • Using cash-back credit cards

Debt relief and refinancing plans can really help in difficult times by improving cash flow. The resulting stress relief that comes with getting debt under control can divert energy towards creating a winning strategy to survive the current crisis and thrive in the future. 

The right accounting firm can provide the expertise needed to decipher your cash flow-to-debt ratio and plan the next steps that will help your business rebound and start moving in the right direction. Contact us for a free consultation.

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