A Chinese proverb says the timely return of a loan makes it easier for you to borrow a second time. No one likes to be indebted, but sometimes we do not have a choice. If you prefer borrowing from financial lending institutions, you must have noticed that they ask for a business plan for a new business, or if you have been in operation, financial statements. Through these financial records, banks can tell whether you are a good candidate for a loan or not. Among the many things they check is your ability to repay a loan, and one criterion used is the cash-debt coverage ratio. So, what exactly is this ratio, and how does it determine your loan eligibility? Let’s tell you more.
Cash Debt Coverage Ratio
According to Corporate Finance Institute, the cash debt coverage ratio is also referred to as the cash flow to debt ratio. It is also known as the current cash debt coverage ratio. It measures a company’s ability to repay its debts by comparing the cash flow received from operations to its total liabilities.
The formula, therefore, entails dividing operating cash flow by total liabilities. It is usually expressed as a percentage such that if you get the result as 0.20, it means the ratio is 20%. Alternatively, it is interpreted that for every dollar of total liabilities, 0.2 cents was obtained from operating activities. The 20% obtained means that the company will pay off 20% of its outstanding debts in one year. However, it can also be expressed in years by dividing the result by 1. Therefore, if you have a cash debt coverage ratio of 0.2, when divided by 1, the resulting figure is 5, meaning that it would take the company 5 years to repay all its debts.
The ideal ratio is 1:1 because it means that the net cash from operating activities can cover the total liabilities. Even if it does not get to be 1, a high ratio is favorable to creditors because it shows your ability to repay your loans is above average. A low ratio indicates future financial hurdles that the company may not overcome and cannot service its debts. However, as Investing for Beginners explains, even highly indebted companies could have a promising future so long as market conditions remain favorable. Therefore, even if your company scores a low cash debt coverage ratio, the lending institution can still offer you a loan considering other factors.
It Should Not be Confused with Debt Service Coverage Ratio
As described, the cash debt coverage ratio formula is: operating cash flow/total business debts. One can easily mistake it for the debt service coverage ratio (DSCR), whose formula is: net operating income/ annual debt payments. Although both are used to assess the ability to repay its loans, the debt service coverage ratio is specifically used to gauge how the cash flow can meet the obligation within one year. Annual debt payments mean any debt obligations that must be repaid within a year. Capital with Strategy further clarifies that the ratio is not just applicable to companies; its creditors also use it on unique projects and borrowers.
In some cases, the taxes, interest payments, and depreciation are removed from the net income to get the net income after all expenditures. However, the formula can still be tweaked a little to have the interest expense added to the principal payments as detailed in Investopedia. The formula shows the debt service coverage ratio as net income divided by principal repayments plus interest expense. Another difference between the DSCR and the cash debt coverage ratio is the interpretation of the resulting figures. While with the cash debt coverage ratio, the ideal result is 1, in the DSCR, the best outcome is greater than one. If it is less than one, it is negative, meaning that you have a negative cash flow, and you are thus bringing in less revenue than what you are spending on borrowing expenses. If it is greater than one, you can comfortably pay off your debts. The ideal ratio of DSCR is two for anyone looking to take on more debt.
Importance of Calculating Solvency Ratios
Solvency should not be confused with liquidity; while solvency assesses its ability to repay long-term debts, liquidity evaluates its capacity to meet short-term obligations. Both ratios are, however, important to creditors to gauge the financial health of a company. So you do not have to wait until you are applying for a loan for a creditor to tell you if the company is heading in the right direction.
According to Quickbooks, besides facilitating your creditworthiness, regularly calculating solvency helps to evaluate the capital structure and determine if it is necessary to redistribute internal and external equities. Furthermore, you may feel like you need a loan, but the solvency ratio indicates otherwise. However, before you take on more obligations, always compare your company’s ratios with other competitors in the industry. As the article enlightens us, utility companies usually have lower solvency ratios than technology firms.
Also, ensure that you maintain records over several years to observe any particular trend. Sometimes, there could be circumstances beyond your control that led to an undesirable ratio. Regardless, regularly checking the ratio helps to see if the financial is improving or getting worse to facilitate a more informed decision. To get a complete picture of the firm’s solvency, you can use other ratios that include debt to equity ratios, interest coverage ratio, asset coverage ratio, among others. The main thing is knowing how to interpret whichever ratio you use and still pay attention to the industry in which you are operating. For instance, for an asset coverage ratio, a utility company is expected to have at least 1.5, while an industrial firm should have at least 2.
Written by Allen Lee
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