Cash Flow to Debt Ratio
The cash flow of a company in relation to its debt serves lenders as another way to measure whether or not to provide debt financing to a business. A company’s profitability, as measured on its books, may be better or worse than its cash generation. In calculating cash flow, only actual cash coming in and going out in a given period is used to calculate net cash available for servicing debt.
The sales of a company for a given period, for example, may be considerably higher than its cash receipts; the reason for this may simply be that the company’s customers may paying late or may have favorable “stretched out” payment arrangements. Similarly, the costs of a company, as recorded on its books, may be lower than its actual cash payments in a period; the company, for instance, may be prepaying insurance for the next six months this month; it’s books will only show one sixth of that payment as cost but six times as much going out as cash. For these reasons, a company may be profitable based on its books but may be short on cash at any given time. Lenders therefore like to look at the amount of cash available to service the current portions of any new debt. If this amount is minimally 1.25 times the debt service required, the business is at least in the ballpark to receive a loan. The higher this ratio, the more inclined the lender will be to lend.
Rules of thumb along these lines are subject to adjustment based on the availability of money. As Daniel Rome Levine pointed out early in 2006, commenting on the money market in Chicago, writing for Crain’s Chicago Business, “[S]ince the 2001 recession, many entrepreneurs have learned to do more with fewer resources and pared down their debt.” Interest rates were low and banks were loosening their terms. “These days,” Levine wrote, “[banks] are going as low as 1.1 times debt for companies with strong balance sheets.” A tightening of money and less favorable small business profiles will once more push the ratio up.
