Operating Cash to Debt Ratio

What Is The Operating Cash-To-Debt Ratio?

The operating cash-to-debt ratio is a financial metric used to gauge how well-equipped a company is to pay off its current debt. It is simply a company’s operating cash flows over its total debt.

The numerator in this type of coverage ratio, or operating cash flow, is a metric that quantifies the cash generated through a company's regular business activities.

It represents the cash flow generated before accounting for capital expenditures. 

On the other hand, free cash flow represents the cash remaining after deducting capital expenditures from operating cash flow.

Some analysts prefer using free cash flow instead of operating cash flow because operating cash flow does not account for capital expenditures.

In this article, we will use operating cash flow since we specifically focus on calculating the operating cash-to-debt ratio. A simple way to think of the operating cash-to-debt ratio is to view it as a coverage ratio.

A coverage ratio is a company’s ability to pay its financial obligations, such as:

• Debt 
• Liabilities
• Dividend payments. 

Another way to look at the operating cash-to-debt ratio is as a time frame to pay off debt.

The operating cash-to-debt ratio represents the time it would take to repay its debt if it used all cash flows for debt repayment. 

However, the ratio itself and the hypothetical debt repayment metric can be good indicators of the overall financial health of a company.

How can we calculate the Operating cash-to-debt ratio?

When calculating the ratio, the steps are somewhat intuitive. To find this ratio, follow these three steps:

Find The Operating Cash Flow

The operating cash flow can be obtained from the company's statement of cash flows. The operating cash flow is usually listed as "Net cash provided by operating activities."

Make sure to use the most recent financial statement available to ensure relevance in your calculations.

Begin Determining The Total Debt

To find this information, look at the company's balance sheet.

Add up the outstanding amounts of all debt obligations to obtain the total debt. Some variations of this ratio will use either short-term or long-term debt to change the ratio.

In this case, we are trying to find operating cash to debt. This means we should find the total debt.

Apply The Formula

Since we know this is a ratio of operating cash flow to total debt, we should intuitively know to set up a quotient for our formula.

As you can see in the formula (below), divide the operating cash flow by the total debt.

Operating Cash Flow to Debt Ratio = (Operating Cash Flow) / (Total Debt)

Operating Cash-to-Debt Ratio Example

Let’s say you have been asked about a software company with debts of $2,000,000.00 and a working capital of $900,000.00.

In this case, we are asked to find the ratio between these two elements of a company’s financials.

Since we already know that finding the ratio is simply dividing total costs by total operating cash flows, we can set up a calculation. 

Operating income to expense ratio = 900,000.00 ÷ 2,000,000.00 = 0.45 or 45% .

This means that if this company were to generate strong cash flow in the future, it would take 1/.45 years or about 2.22 years to pay off the entire debt.

If the ratio were .25 or 25%, paying off the loan would take 4 years because we know that 1/.25 is 4.

Now, let’s pretend the ratio was 1-to-1 or just 1.

A ratio of 1 is usually a good sign because the company has sufficient cash to meet its debt obligations. In fact, this ratio of 1 would indicate that the company actually has enough cash to cover all of its debt.

You could argue that a firm with an operating cash flow of 4 is better off financially than the second firm with a 2. However, this approach does not guarantee the future of the first firm

We need to analyze the concept further to determine what high and low ratios are and how we can use them intelligently.

Operating Cash-to-Debt Ratio Interpretation

In general, there are two primary functions of the operating cash-to-debt ratio.

1. To assess the historical performance of a company 
2. To compare multiple companies, particularly companies that exist in the same industry.

The ratio can be tracked over time and easily marked and compared as an increasing or decreasing ratio.  Say that the operating cash-to-debt ratio increases every year for 10 years.

We can interpret this gradual increase as evidence to say that the company has performed well financially. The ratio can be used to compare companies, but not all companies.

For example, let’s say that Industry 1 has an average ratio of 2. Now, let’s say that Industry 2 has an average ratio of .25. You are asked to compare two companies’ ratios, with one company in Industry 1 and another in Industry 2. 

The company in Industry 1 has a ratio of 2. The company in Industry 2 has a ratio of 1.8. If you look at only the ratios, you would say that the first company has a higher operating cash-to-debt ratio. 

In reality, the first company has an average or normal ratio in its industry, and the second company is an outlier in its respective industry, with a very high ratio.

When comparing ratios, such as the operating cash-to-debt ratio, the concept of relativity is very important when trying to make interpretations about different companies. 

Uses Of Operating Cash-To-Debt Ratio

Here are five common ways that the operating cash-to-debt ratio can be used. 

1. Assessing Financial Stability: The ratio indicates a company's ability to generate sufficient operating cash flow to cover its debt obligations. 
   • A higher ratio suggests a stronger financial position and a more remarkable ability to repay debts, indicating better financial stability. A higher ratio can be regarded as positive. On the other hand, a lower ratio means that a company is less equipped to pay off its debt obligations.
2. Evaluating Liquidity: The ratio helps assess a company's liquidity by considering its cash flow with its debt. A higher ratio indicates a greater ability to meet short-term financial obligations and reduces the risk of cash flow difficulties.
3. Identifying Financial Risks: A low ratio can be a signal for potential financial risks. It suggests the company may struggle to generate sufficient cash flow to cover its debts, indicating a higher risk.
4. Making Investment Decisions: A higher ratio may indicate a more financially sound company, potentially making it an attractive investment opportunity. 
   • Conversely, a lower ratio can indicate a company with more risk and financial uncertainty. Thus, making it a less attractive investment.
5. Creditworthiness Assessment: Lenders and creditors may use the ratio to assess a company's creditworthiness before extending credit or loans. A higher ratio indicates a lower risk of default and may result in more favorable lending terms.

What Defines A High Operating Cash-To-Debt Ratio?

A high operating cash-to-debt ratio generally indicates a stronger financial position. This means that the company has great potential to use cash flow from operations to meet its debt obligations.

While the specific threshold for what is considered a high ratio may vary depending on the industry and company circumstances, a ratio above 1 is typically regarded as favorable. Here are four major characteristics of a high operating cash-to-debt ratio:

Comfortable Debt Coverage

A high ratio implies that the company's operating cash flow is significantly higher than its total debt. This indicates that the company has ample cash flow to comfortably cover its debt obligations, reducing the risk of default or financial distress.

Strong Cash Generation

A high ratio suggests that the company is generating robust cash flow from its operations. It indicates that the company's core business activities are generating sufficient funds to not only cover its operating expenses but also leave a surplus to service its debt.

Favorable Liquidity Position

A high operating cash-to-debt ratio signifies that the company has strong liquidity. Liquidity is a business's ability to pay off future debts. 

It implies that the company can quickly meet its short-term financial obligations, such as interest payments and loan repayments, without relying on external financing or facing cash flow constraints.

Ability To Invest And Grow

A high ratio suggests that the company has internal resources to invest in company growth. A high ratio indicates that the company can allocate funds to investments while still maintaining a healthy cash flow position to manage its debt.

As previously discussed, it is essential to consider industry benchmarks and compare the company's ratio with its peers when assessing whether the operating cash-to-debt ratio is high.

Different industries may have different standards and financial dynamics that influence what is considered a high ratio. This is why ratios should only be used to compare companies’ previous years or companies in the same industry. 

Additionally, it's essential to analyze other financial factors and the company's overall financial health to understand its financial position comprehensively.

Increasing Operating Cash To Debt Ratio

Here are some actual ways that any company could increase its operating cash-to-debt ratio.

Increase Operating Cash Flow

Companies can do this by improving the following: 

• Revenue generation 
• Increasing sales volume 
• Implementing effective pricing strategies
• Exploring new market opportunities to boost overall revenue.

Companies can control operating expenses by:

• Reducing unnecessary expenses 
• Negotiating favorable terms with suppliersStreamlining operations to improve cost efficiency.

Companies can also optimize working capital management by

• Managing inventory levels
• Shortening accounts receivable collection periods
• Extending accounts payable payment terms to improve cash flow within the operating cycle.

All of these methods directly increase operating cash flow, which can increase the operating cash-to-debt ratio of a company.

Decrease Debt

Companies can consider refinancing existing debt to secure more favorable interest rates or extend repayment periods, which can reduce the financial burden. Companies can also restructure current debt contracts to find better interest rates.

Researched & Authored by Alex Bellucci | LinkedIn

Reviewed and Edited by Shahrukh Azim Butt | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Cash Conversion Ratio

• Debt Equity Ratio

• Debt Service Coverage Ratio

• Price-to-Cash Flow Ratio

• Unconventional Cash Flow