**Cash flow coverage ratio** is one of the important ratios to measure the liquidity of the company.

It shows the ability of the company to cover its total debt in terms of the operating cash flow.

In this article, we will include what the cash flow coverage ratio is, its formula, how to calculate it, an example, and why it is important.

## What is the Cash Flow Coverage Ratio

The cash flow coverage ratio is a liquidity ratio that measures the ability of a company to pay its debt in comparison to its operating cash flow.

It compares the company’s operating cash flow with its total debt. In other words, you get the **CFCR** by dividing the operating cash flow by the total debt.

**Formula:**

it shows whether the company is generating enough cash to pay its debt or not. This ratio is used by a wide group of individuals.

However, we will discuss its formula and use later on. First, let’s understand some basic information.

**Operating Activities:**

The cash flow statement is one of the main financial statements that a company publishes to provide financial data. Generally, it contains three types of activities:

1. Operating activities

2. Investing activities

3. Financial activities

Operating activities are related to the business’s core operations such as sales, cost of goods, and employees salaries.

At the end of this section, net cash flow is calculated by subtracting cash outflows from cash inflows, which is also referred to as operating cash flow.

**Formula:**

Many professionals use free cash flow instead of operating cash flow. Free cash flow substrates capital expenditures from the operating cash flow to get more accurate results.

\text{Free Cash Flow} = \text{Operating Cash Flow} - \text{Capex}

**Total Debt:**

Total debt is the company’s liabilities that they owe. Total debt contains short-term and long-term debt. Every company needs to finance its business, and they take loans from the market, like bank loans.

Total debt is located in the liabilities section of the balance sheet. Generally, investors use short-term debt to calculate the cash flow coverage ratio, but you can use total debt to analyse the ability of the company.

## Calculate Cash Flow Coverage Ratio

Calculating the CFCR is not rocket science. We just need two figures from the financial statement discussed above: operating cash flow and total debt.

### Cash Flow Coverage Ratio Formula

The formula is straightforward. Compare the company’s operating cash flow with its total debt:

\text{Cash Flow Coverage Ratio} = \frac{\text{Operating Cash Flow}}{\text{Total Debt}}

This ratio measures how much the company’s operating cash flow covers its total debt. If the ratio is less than one, it means the company is not generating enough cash to pay its debt. A ratio higher than one indicates that the company has sufficient cash to pay its debt.

Alternatively, you can use **EBITDA** (Earnings Before Interest, Taxes, Depreciation, and Amortisation) instead of operating cash flow. The formula becomes:

Additionally, using the cash flow coverage ratio, we can calculate how many years a company needs to pay its total debt. To do this, divide the **CFCR** by one:

### Cash flow coverage ratio Example

Let’s consider a hypothetical company, ABC, with a net operating cash flow of $2 million and total debt of $1.5 million.

**Calculate the ratio:**

Here, the ratio value is 1.34, indicating that the company can cover its total debt with operating cash flow.

Expressing this ratio in percentage form:

\text{CFCR} = 0.8 \times 100 = 80\%

This means ABC company can cover 80% of its **debt** with its operating cash flow. The internal team should focus on cash flow management to improve the ratio to 1.0.

The ideal ratio is 1.5, signifying that the company’s operating cash flow can cover 150% of its debts. A ratio higher than one is safe for business, as it can withstand sudden crises.

In this example, ABC company needs 1.25 years to cover its total debt:

\text{Years to Cover Total Debt} = \frac{1}{0.8} = 1.25 \text{ years}

## Cash Flow Coverage Ratio Analysis

In terms of calculating, the CFCR may seem simple, but it holds significant importance. Various groups, including internal teams, investors, and lenders, use this formula to analyse the company’s ability to pay its debts.

**Internal Team:**

professionals use this ratio to determine whether the company is generating enough money. A low ratio indicates a need for improvement, prompting a focus on enhancing the ratio through various cash flow management techniques.

A higher ratio suggests that the company can allocate funds for business purposes like capital investment or dividends.

**Investors:**

Investors seek returns on their investments, and the CFCR provides insight into a company’s ability to pay its debts. A low ratio indicates a higher financial risk, potentially deterring investors.

Conversely, a ratio higher than 1 signifies lower financial risk, making the company more attractive to investors. A high ratio may also indicate profit distribution to shareholders through dividends.

**Lenders:**

Lenders, especially bank loan providers, use the cash flow coverage ratio to assess a company’s creditworthiness. By analysing total debt and generated cash flow, lenders can gauge whether the company can repay a loan.

If a company has high existing debt compared to operating cash flow, lenders may be cautious about approving the loan, as it signifies a higher risk.

## Conclusion

To summarise, the **cash flow coverage ratio** compares a company’s total debt with its operating cash flow to measure its ability to meet financial obligations.

While a single ratio provides valuable information, it acknowledges that relying solely on this single ratio may not provide a comprehensive financial view.

Exploring other cash flow ratios offers a more comprehensive view of the company’s financial position.

Here are 7 best cash flow ratios that can offer insights into the actual financial health of the company. Must read it.