Cash Flow to Debt Ratio

For many businesses, taking on debt is a necessary part of operations. Whether it’s the initial funds to get launched, an injection of capital for a big purchase, or a bit of a buffer for a down period, it’s incredibly common.

But how much debt is financially healthy?

To answer this question, financial experts don’t just look at the total debt amount. They also use different ratios which measure a business’s ability to pay down its debt.

One of the ratios used is the cash flow to debt ratio.

Let’s break it down into its components, show how the calculation is done, and talk about why this is a number you should be tracking.

What is Cash Flow to Debt Ratio?

Cash flow to debt ratio is a metric businesses use to understand its ability to pay down its debt based on its operating cash flow.

Operating cash flow is the cash entering and leaving due to a company’s core operations. This includes sales revenue, cost of goods sold, cost of service, and operating expenses.

By comparing your operating cash flow to your total debt, you can reach conclusions about how long it will take you to pay your debt, whether you’re at risk of defaulting, or whether your operations can easily generate enough cash to tend to your liabilities.

Essentially, business owners and investors use this metric to determine how financially sustainable a business is.

How to Calculate Cash Flow to Debt Ratio

To calculate cash flow to debt ratio, you need two numbers:

  • Total debt: All of your short-term and long-term outstanding liabilities at the end of a period of time.
  • Operating cash flow: The cash generated from a company’s core operations over a period of time.

With these metrics, simply plug them into this formula:

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

You can find these numbers in your financial reporting.

Total debt is easily found on your balance sheet. Simply look at the balance of your liabilities to find the total.

Operating cash flow is harder to find. Unless your accounting platform already provides this metric, you’ll need to do a manual calculation.

For smaller businesses with simple accounting, operating cash flow can be found by totalling up all cash revenue and subtracting all cash expenses. This requires manually tallying up amounts from your transaction history.

For businesses with more complex accounting, start with your net income for the period. Then adjust for any non-cash activity that’s included in the net income calculation.

This means accounting for changes to accounts receivable, accounts payable, and non-cash expenses like amortization or depreciation.

Why is Cash Flow to Debt Ratio Important?

Almost every small to medium sized business takes on debt to grow their business. In 2021, 74% of small to medium businesses had outstanding debt with just 11% having debt less than $25,000.

Debt serves a practical purpose. But by definition, it also needs to be paid back.

If this debt can be paid down using cash flow from operations, the debt starts to look sustainable.

The higher the cash flow to debt ratio, the more likely it is that a business is generating enough cash flow to cover its debt payments.

On the flip side, a lower cash flow to debt ratio indicates that a business isn’t generating enough cash flow in its day-to-day operations to pay down its debt.

These businesses might have to look at alternative funding to cover the near future or find ways to boost their cash flow to become sustainable.

Whether you’re a business owner, investor, or manage a business’s finances, the cash flow to debt ratio is important to keep track of to avoid any potential problems covering debt payments down the line.

What’s a Good Cash Flow to Debt Ratio?

Unfortunately, there’s no north star for what’s a good cash flow to debt ratio.

When looking at the cash flow to debt ratio of any business, it’s important to understand it within its context. Different industries and sized businesses have different levels of tolerance for debt.

For example, a recently formed startup who just started making sales will have a very low cash flow to debt ratio. But as a startup, they’re focused on growing their operations and will track how this metric changes over time.

A Cash Flow to Debt Ratio Example

Let’s imagine two businesses: a consulting firm and a bike manufacturer. Both businesses bring in $2 million in annual revenue and are looking to grow.

For the consulting firm, they’re planning on spending money on marketing and hiring extra employees to take on any new clients.

For the bike manufacturer, if they want to increase their production they’ll need new equipment and upgrade their storage for all the additional stock.

The consulting firm doesn’t need to take on new debt to increase their operations, they’re only tending to an outstanding $500,000 mortgage for their office space.

But the bike manufacturer needs to take out a $5 million loan for machinery and new real estate to expand. The two ratios are:

Consulting Cash Flow to Debt Ratio = $2M / $500,000 = 4

Manufacturer Cash Flow to Debt Ratio = $2M / $5M = 0.4

The consulting firm doesn’t depend on debt. Their astronomically high cash flow to debt ratio shows that. But that doesn’t mean the bike manufacturer has a bad cash flow to debt ratio once you understand the context.

Once the bike manufacturer increases production, they will increase their cash flow and pay down their debt. Their cash flow to debt ratio will increase over time.

For businesses that depend on capital expenditures (like bike manufacturers), tracking your cash flow to debt ratio over time and tracking how it changes is just as important as calculating it for a single moment in time.

How to Improve Your Cash Flow to Debt Ratio

There are two components to the cash flow to debt ratio: cash flow from operations and total debt. To improve the ratio, you need to look into one of these factors.

Increasing Cash Flow

To improve your cash flow, you need to either increase the amount of money coming in or decrease what’s going out.

Increasing your marketing efforts can pay off so long as you’re keeping your sales and marketing spend in check.

Organic marketing like running a blog or having a social media presence usually has low cash costs but high time investment. Or consider affiliate programs where users do the marketing for you for a cut of the sale.

Of course, if boosting revenue was easy you’d be doing it already. So then it’s time to turn your attention to your expenses.

Start with any direct costs of production you have.

Cutting down on direct costs increases your profit margins which means more cash flow for your business from every sale.

You might be able to negotiate better terms from another supplier or renegotiate with your current providers, potentially getting a discount for ordering in bulk.

Get critical with your operating costs, as well.

Review your budget or create one if you aren’t using one already. Start by defining the absolute essential costs so you know where you can trim the fat and improve your cash flow.

Finally, look into options for turning your assets into cash quicker. This means speeding up accounts receivable collections or liquidating inventory that’s collecting dust.

Decreasing Total Debt

While decreasing your total debt quickly is tough, it’s not impossible.

The easiest first step to take is staying up to date with any debt payments. Avoiding any penalties or unnecessary interest keeps your balances low.

Paying down balances early is a great option if you have some extra money, but make sure you aren’t penalized for prepayments.

Some debt like loans have strict terms about payment amounts and will actually penalize you for paying down the debt early.

You can also investigate refinancing options.

When refinancing, you could potentially pay down a portion of the balance early as you restructure your debts. Or if you can afford it, negotiating for larger monthly payments ensures you’re paying down your balance as fast as possible.

If you do need to take on debt, consider a line of credit instead of a loan. With a line of credit, you only need to take out as much as you need at a time. So if the bank is offering you $10,000 when you only need $5,000, you don’t feel obliged to take the extra $5,000 that will hurt your ratio.

Don’t make hasty decisions when looking to improve your cash flow to debt ratio.

Remember, it’s a metric that’s a snapshot in time and how it changes as time passes is just as, if not more, important than what it is at a specific moment. So long as you’re tending to your debts responsibly, it will improve over time.

Optimizing Your Cash Flow to Debt Ratio With Finmark

Measuring your cash flow to debt ratio and its separate components provides crucial insight into your business’s financial health. Having to manually calculate it shouldn’t block you from tracking this metric.

Finmark from BILL’s financial planning tools help you with pre-built and customizable reports that let you build once and track forever. No more stressful sessions with a calculator, just peace of mind in knowing your numbers.

Try a free trial of Finmark today.

This content is presented “as is,” and is not intended to provide tax, legal or financial advice. Please consult your advisor with any questions.