Naturally, a company must be able to pay off its obligations with the operating cash flows it has. This ability is measured with the help of a liquidity ratio that’s known as cash flow coverage.
More specifically, the cash flow coverage ratio shows if a company is able to pay off its current expenses or debt with its cash flow from operations – simple! This ratio shows the available amount of money for a certain company to meet its current obligations.
Due to the fact that it shows how many times earnings can cover certain obligations, such as interest on short-term notes, rent, and preferred dividends, this ratio is seen as being multiple – it is a visualization of current liquidity.
The Basics of the Cash Flow Coverage Ratio
Using this kind of measurement, stakeholders, creditors, and investors are shown an overview of the operating efficiency of a certain company. A huge cash flow ratio means that a company can do whatever it wants – as they appear to have infinite amounts of cash.
For example, if you would like to relate this ratio to your own personal life, you could think of it as that little extra at the end of the month – after you’ve paid your rent and bills – that you can safely put away in your savings account.
On the other hand, if a company has a sufficient cash flow coverage ratio, the latter can pose as a safety net, ready to support the company if the business cycles get slower.
If you own a business, you can be sure that a bank will check this ratio if you want to make a loan for the said business. This is done in order to determine the repayment risk they would take if they are to approve your loan.
The Formula of the Cash Flow Coverage
Depending on the cash flow amounts that you want to include, there are mainly two ways through which you can come up with the cash flow coverage of your business.
On one hand, it can be calculated by dividing the Operating Cash Flows to the Total Debt of your company. On the other hand, you can add the EBIT (earnings before interest and taxed) to the depreciation and amortization, and then divide these to the total debt.
As we mentioned, it depends on the variables that have to be included in the equation – you have to take in consideration those that matter for you in order to come up with the correct cash flow coverage.
So, this has been stated before but, you could think of the cash flow coverage as your business’ safety net. Let’s say that you have a poor month, so to say. By doing one of the equations detailed above, you will find out whether your company can still pay off its obligations or not.
Moreover, if you are to apply for a loan, the bank will analyze the cash flow coverage ratio in relation to the new debt – the one after the loan. If the ratio decreases, that means there’s a greater risk for late payments or for your business to default – case in which you will be denied the loan.