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With money flowing in and out of accounts, how do you know if your business is taking in sufficient earnings to pay the bills? One quick measure of liquidity to look at is the cash flow coverage ratio. This compares cash flow with debt to see where a business stands financially. In this guide, we’ll cover the basics of the cash flow coverage ratio including its formula, applications, and analysis.
What is the cash flow coverage ratio?
The cash flow coverage ratio is a liquidity formula that shows the relationship between a company’s total debt and operating cash flow. In other words, it shows how well a company can pay its debts using cash from operations.
This measurement is frequently used by internal and external stakeholders, including investors, to assess a company’s efficiency. A high cash flow ratio shows that the business takes in plenty of cash to cover its obligations with room to spare. A low cash flow coverage ratio indicates that the business is struggling with debt. This is why lenders look at it carefully as part of any business loan application.
How to calculate cash flow coverage ratio
There are several cash flow coverage ratio formulas to choose from, but here is the most straightforward option:
Cash Flow Coverage Ratio = Operating Cash Flows / Total Debt
To calculate the cash flow coverage ratio, you then simply review your company’s financial statements to find all outstanding liabilities and operating cash flows. For example, imagine Company ABC wishes to take out a business loan. The bank uses the cash flow coverage ratio formula to assess creditworthiness.
Step 1: Review the cash flow statement to find operating cash flows. In the previous accounting year, these totalled £100,000.
Step 2: Review the cash flow statement to find payable debt for the previous accounting year. This totalled £25,000.
Step 3: Plug these figures into the formula. 100,000 / 25,000 is 4.
This means that Company ABC was able to generate four times more cash flow than needed to cover its obligations in the past year. If this meets the bank’s threshold, the loan will be approved.
What is a good cash flow coverage ratio?
In most industries, the example above would be a prime example of a good cash flow coverage ratio. Generally, businesses aim for a minimum of 1.5 to comfortably pay debt with operating cash flows. When the number falls below this threshold, it’s time to work on debt management strategies. It’s good for businesses to have a little safety net in terms of operating cash flows. That way, they’re still able to pay the bills during slower sales periods or a market downturn.
What is cash flow coverage ratio used for?
We’ve already mentioned how this calculation is used by banks and other lenders to assess a business’s ability to pay back loans. Investors use the ratio to determine whether a business will be able to pay dividends on time. However, it’s also a useful internal metric to follow. You can check it before making strategic business decisions such as expanding into a new market or purchasing a major asset. A high ratio allows you to accelerate debt repayments so that you can use more of your profits later.
If your cash flow coverage ratio is lower than 1, it’s time to look at how you’re using your resources to pay off debt. You will need to make other areas of operations more efficient to free up cash flows. Chasing late payments takes a serious toll on any business’s cash flow. With GoCardless, you can reduce debtor days by collecting payment on the day it’s due. Choose from instant, one-off payments or automated recurring payments using Direct Debit. This saves time for you and your customers, while improving cash flow.
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