Cash Flow Coverage Ratio

Definition

The term cash flow coverage ratio refers to a metric that allows the investor-analyst to understand the ability of a company to meet all of its non-expense costs. Examples of non-expense costs include capital expenditures, dividend payments, and repayment of debt.

Calculation

Cash Flow Coverage = (Debt Payments + Dividends + Capital Expenditures) / Cash Flow for the Period
Where:

  • Cash Flow for the Period is equal to net income plus non-cash expenses minus non-cash sales.
  • Non-cash expenses are equal to depreciation and amortization expense.

Explanation

Cash flow measures allow the investor-analyst to understand if the company is generating enough cash flow from ongoing operations to keep the company in a financially sound position over the long term. One of the ways to understand the ability of a company to meet its non-expense-related financial obligations is to calculate their cash flow coverage ratio.

The investor-analyst can calculate a company's cash flow coverage ratio if they wish to understand if a company's is generating enough cash to pay for non-expense costs. This measure supplements metrics such as fixed charge coverage and is of particular interest when examining companies that are rapidly expanding in terms of capital projects and / or companies that are already heavily in debt.

The metric takes the sum of non-expense costs such as the repayment of debt, stock dividends, and capital expenditures and divides it by the cash flow generated in the same period. Cash flow for the period would be equal to the company's net income plus non-cash expenses (such as depreciation and amortization), minus non-cash sales. Ideally, a company's ratio would be in excess of 1.0; however, the investor-analyst must carefully consider the nature of debt payments used in the calculation. This is especially true if the company has an unusually large debt payment due in the period examined.

Example

Company ABC's CFO is concerned about the company's ability to generate enough cash to pay for its upcoming debt payments and planned capital expansion costs. The CFO asked her analytical team to calculate the company's cash flow coverage ratio. The analysts learned the company has upcoming debt payments of $2,250,000, dividends of $750,000, and has planned for $2,000,000 in capital costs. Net income in the period is projected to be $4,250,000, with depreciation expense of $500,000 and $50,000 in non-cash sales.

Calculating the cash flow coverage ratio:

= ($2,250,000 + $750,000 + $2,000,000) / ($4,250,000 + $500,000 - $50,000)
= $5,000,000 / $4,700,000, or 1.06

Based upon this information, the CFO asked operations to delay half their capital expansion plans until the following year; resulting in a cash flow coverage ratio of 0.85.

Related Terms

cash receipts to billed sales, cash to current assets ratio, cash to current liabilities, expense coverage days