Cash flow to creditors is essential for investors, professionals, and creditors. This formula provides insight into the company’s debt and its actual financial position.
This ratio helps the company when applying for a business loan, that the bank can analyze and calculate the CFC formula to ensure how much debt the company has and how much it can afford.
That’s why understanding the cash flow to creditors formula is important. Here, we will discuss what it is, its formula, how to calculate it, and a real-life example.
What is cash flow to creditors
Cash flow to creditors shows how much money goes from the company to its creditors in the form of interest payments and debt repayments. It is the outflow of cash from the company to its creditors as part of its debt service.
Creditors can be those you owe money to, such as suppliers, banks, or private lenders. All companies need financial help to run their business and expand, leading them to borrow money from the market. The interest rate may vary for all lenders and depends on the company’s credibility.
CFC gives the internal team and investors an idea about the company’s debt. It suggests the management team optimize debt payment, while investors assess the profitability of the company.
To understand the cash flow to creditors formula and calculation, let’s look at some basic cash flow statement concepts.
What is a cash flow statement
A cash flow statement is a financial report published by the company, including all sources of the company’s cash inflow and outflow. This statement is divided into three parts: operating activities, investing activities, and financial activities.
Here is a brief description of them:
Operating activities: activities related to the core business of the company, such as selling products and paying salaries.
Investing activities: activities related to company investments, like buying equipment and selling land.
Financial activities: describe the cash inflow and outflow of the company’s financial, including taking loans and repaying debt.
This section is important for calculating the CFC formula because it includes activities related to it.
Cash flow to creditors formula
Calculating CFC is simple. We need to take some components from the statement.
To calculate the cash flow to creditors formula, subtract the value of ending debt from paid interest and add the beginning debt of the accounting period.
Here is the cash flow to creditors formula:
\text{CFC} = \text{I} - \text{E} + \text{B}
Here,
CFC: cash flow to creditors
I: paid interest
beginning debt (B): refers to the total outstanding amount of debt a company has at the starting of a specific accounting period.
Ending debt (E): refers to the total outstanding amount of debt a company has at the conclusion of a specific accounting period.
Let’s understand the CFC formula.
This formula shows how much money the company paid to its creditors. The first component is interest paid to creditors, which was for the loan taken by the company.
The next component is the difference in debt at the accounting period. Subtract the ending debt and add the beginning debt to find out. This difference will show the increase or decrease of the company.
A high cash flow to creditors indicates increasing debt, leading to negative cash flow, whereas decreasing debt shows the company is paying its debt on time and generating enough cash to run the company.
Cash flow to creditors example:
Imagine ABC Corporation paid $60,000 in interest on its outstanding debt during a specific period. Additionally, they borrowed $50,000 in new loans but also repaid $30,000 of existing debt during the same period.
Using the formula:
\text{Cash Flow to Creditors} = \text{Interest Paid} - \text{Net New Borrowing}
Substituting the values:
\text{CFC} = \$60,000 - (\$50,000 - \$30,000) = \$40,000
Here, ABC Corporation’s cash flow to creditors for the given period would be $40,000.
Cash flow to creditors Importance
Cash flow to creditors formula helps in analysing the company’s debt and is used by investors, creditors, and the management team.
This ratio shows signs of profitability, suggesting management work on debt optimization.
Remember, CFC can be negative, indicating the company heavily pays the debt and depends on it. This is a bad signal for investors, and the internal team should work on cutting unnecessary expenses.
Investors want to know how much cash the company is spending on paying the principal amount of the loan and interest. It indicates the future growth of the company, which is necessary for investors.
This ratio is also used to attract investors. A lower ratio indicates the company is generating enough cash to meet its debt, making it attractive for investment and attracting new investors.
Cash flow to creditors reflects the creditworthiness of the company, helping creditors (banks) approve loans by understanding how the company manages its debt. If it already has high debt, it means high risk is involved, and paying back the loan has a low probability.
Conclusion
In summary, this ratio is a valuable tool for managing a company’s debt. I recommend not relying solely on one formula to understand the company’s actual position. Utilizing multiple cash flow ratios will provide a comprehensive review of the company.
Here is my article on the 7 best cash flow ratios. It will offer you a better perspective for analyzing a company.