Understanding Your Cash Flow Coverage Ratio (2024)

FAQs

Understanding Your Cash Flow Coverage Ratio? ›

The cash flow coverage ratio is calculated by dividing the operating cash flow (OCF) of a company by the total debt balance in the corresponding period. From the perspective of evaluating the solvency of a borrower, a higher cash flow coverage ratio is preferable.

Typically, the cash flow coverage ratio for most businesses should be at least 1.5x. This means that there is at least $1.50 in operating cash flows to pay off every $1 of interest payments.

The higher your cash coverage ratio, the better the financial condition your business is in. But how do you know when you should be concerned? Any time that your cash coverage ratio drops below 2 can signal financial issues, while a drop below 1 means your business is in danger of defaulting on its debts.

Interpreting the cash flow coverage ratio

A higher ratio indicates stronger financial health, showcasing your business's ability to meet its debt obligations efficiently. Conversely, if this liquidity ratio is below one could signal potential issues, a red flag for both investors and creditors.

Interpretation of Interest Coverage Ratio

The lower the interest coverage ratio, the greater the company's debt and the possibility of bankruptcy. Intuitively, a lower ratio indicates that less operating profits are available to meet interest payments and that the company is more vulnerable to volatile interest rates.

An operating cash flow ratio of less than one indicates the opposite—the firm has not generated enough cash to cover its current liabilities. To investors and analysts, a low ratio could mean that the firm needs more capital. However, there could be many interpretations, not all of which point to poor financial health.

Analysts prefer to see a coverage ratio of three (or higher). A coverage ratio below one indicates a company cannot meet its current interest payment obligations and, therefore, is not in good financial health.

The higher the coverage ratio, the easier it should be to make interest payments on its debt or pay dividends. Coverage ratios come in several forms and can be used to help identify companies in a potentially troubled financial situation.

Key Takeaways

A ratio less than 1 indicates short-term cash flow problems; a ratio greater than 1 indicates good financial health, as it indicates cash flow more than sufficient to meet short-term financial obligations.

There is no ideal figure, but a ratio of at least 0.5 to 1 is usually preferred. The cash ratio may not provide a good overall analysis of a company, as it is unrealistic for companies to hold large amounts of cash.

What is a bad coverage ratio? ›

On the other hand, a “bad” interest coverage ratio is any number less than one, because this means that your business's earnings aren't sufficiently high enough to service your outstanding debt.

Operating Cash Flow Ratio Analysis

Generally, a ratio over 1 is considered to be desirable, while a ratio lower than that indicates strained financial standing of the firm.

This is a figure that's often used by lenders or investors to better understand an organization's risk level in relation to its current debt. Generally speaking, the higher the coverage ratio, the better.

An interest coverage ratio of 1.5 is considered as healthy for a business. In general, a higher interest coverage ratio means that a company is earning sufficient money in order to pay off the interests due on long term loans, which indicates that there is a very less chance of a financial default.

An interest coverage ratio of 1.5 is one where lenders will likely refuse to lend the company more money, as the company's risk for default may be perceived as high. If a company's ratio is below one, it will likely need to spend some of its cash reserves to meet the difference or borrow more.

The cash flow coverage ratio is calculated by dividing the operating cash flow (OCF) of a company by the total debt balance in the corresponding period. From the perspective of evaluating the solvency of a borrower, a higher cash flow coverage ratio is preferable.

To have a healthy free cash flow, you want to have enough free cash on hand to be able to pay all of your company's bills and costs for a month, and the more you surpass that number, the better. Some investors and analysts believe that a good free cash flow for a SaaS company is anywhere from about 20% to 25%.