What is current cash debt coverage ratio? – Definition:
Current cash debt coverage ratio is a liquidity ratio that is used to measure how efficient the entity is with its cash management.
In other words, current cash debt coverage ratio, as the name suggests, measures the entity’s ability to pay off its current debts with the operating cash inflow it is able to receive during an accounting period.
Formula: How to calculate current cash debt coverage ratio
Current cash debt coverage ratio is calculated by extracting the net cash flow from operating activities from the Statement of Cash flow and then, dividing it by average liabilities of the company.
Financial analysis is an important tool to gauge the value and progress of a company. By applying formulas to specific line items of the financial statements, we can calculate quantitative measures that are also referred to as ‘ratios’. These ratios (including profitability ratios, liquidity ratios, solvency ratios, activity ratios) act as a metric to assess the financial performance of an entity. It allows us to make comparison of the current year financials of an entity with either its past year’s performance, with the competitors’ current year performance, or with the overall performance of the sector or industry.
Similarly, a current cash debt coverage ratio is a quantitative value used to gauge the liquidity of a company. It gets classified under the head of liquidity ratios as it is used to determine the entity’s ability to cover its current accrued expenses (that are due in the next 12 months) with the cash flow received from its primary business activities.
A current cash debt coverage ratio is crucial to investors or potential investors to judge the solvency of an entity. It gives away two potential facts about the company’s cash management:
- Does it generate enough cash from its operations to continue business?
- Does it generate enough cash from its operations to pay timely dividends?
In terms of business, liquidity is more essential than generating profits to continue day-to-day activities. There are enough examples out there in the world to testify that a business usually shuts down due to liquidity crisis more than low or no generation of profits.
The ultimate purpose of a current cash debt coverage ratio is to identify whether the company can cover its debt with the current operating cash flow generation or not.
A high amount of net cash flow from operating activities results in a higher cash coverage debt ratio. There is no standard or acceptable amount of operating cash flow since it can vary business to business; however, it should be of a value higher than the average current liabilities balance. A cash debt coverage ratio of 1 or higher implies that the business is liquid enough to clear all of its debts on time.
Similarly, a low amount of net cash flow from operating activities resulting in a cash debt coverage ratio of less than 1 is an indication of low liquidity in a firm. This means that the business is unable to pay off its current debts since it isn’t even generating enough cash flow to begin with.
For example company ABC had the following balances at the end of the year 2018:
|Cash Flow from Operating Activities||300,000|
|Current Liabilities at Beginning of Year||150,000|
|Current Liabilities at End of Year||250,000|
Calculate average current liabilities = $200,000
Apply the given figures to current cash debt coverage ratio
Current cash debt coverage ratio = = 1.5
From the above example, it can be concluded that company ABC is liquid enough to cover its current debts conveniently with the annual cash generation from operating activities. It doesn’t need to acquire loans or apply for other forms of credit to clear its debts on time and is doing just fine as an entity.
Significance of current cash debt coverage ratio
The one thing that stands the current cash debt coverage ratio out from its other fellow liquidity ratios is that it calculates the ratio on the basis of average current liabilities. Instead of taking just one aspect of a year, it accounts for the past and future performance, both, of an entity in terms of making debt payments.
This allows investors to identify both the factors clearly, the firm’s ability to pay dividends on time and a forecast of the firm’s future liquidity position as well.