Cash Flow Coverage Ratios

There are several cash flow coverage ratios. Let’s look at two that impact all sizes of companies, including small ones.

Some Preliminaries

The reason I will only discuss two of these ratios is that some of the others rarely impact small companies that are privately and/or closely owned. In both of the ratios we will look at OCF stands for operating cash flow. As a reminder, OCF is calculated as:

Net Income adjusted for non-cash charges and changes in current assets and liabilities. Again for this calculation net income is exclusive of the effect of interest and income taxes. See Operating Cash Flow Defined for more on the OCF.

The Capital Expenditure Coverage Ratio

The capital expenditure coverage ratio is calculated using the following formula:

Capital Expenditure Coverage Ratio = OCF / Capital Expenditures

Short-Term Debt Coverage Ratio

The short-term debt coverage ratio is calculated using the following formula:

Short-Term Debt Coverage Ratio = OCF / Short-term Debt

An Example

Assume a company made $80,000 in capital expenditures during the year and that the OCF is as shown in the following:
calculating operating cash flowAlso, assume that the company has short-term debt of $30,000 in the form of a line of credit and that the current portion of its long-term debt is $60,000.

Using this we can make the following calculations for these two important ratios.

Capital Expenditure Coverage Ratio = OCF / Capital Expenditures

Capital Expenditure Coverage Ratio = $156,815 / $80,000

Capital Expenditure Coverage Ratio = 1.96

Short-Term Debt Coverage Ratio = OCF / Short-term Debt

Short-Term Debt Coverage Ratio = $156,815 / ($30,000 + $60,000)

Short-Term Debt Coverage Ratio = 1.74

Note that these calculations are intended to show how well a company can cover short-term obligations. On the surface it appears that the capital expenditure coverage ratio and the short-term debt coverage ratio are adequate. But, let’s look at the two in combination.

Combined = OCF / Capital Expenditures + Short-term Debt

Combined = $156,815 / ($80,000 + $30,000 + $60,000)

Combined = .92

As you can see, when we combine the capital expenditures and the short-term debt the coverage by the operating cash flow is not nearly as large. In fact, this company would be wise to carefully evaluate the amount of capital purchases it makes and also any additional debt it may consider assuming.

Although the financial picture based on these two ratios individually look adequate at present, when we combine them it is easy to see how easily liquidity can be eroded.

Are these ratios that apply to your company? If so, you should consider tracking both of these metrics.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.


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