Optimizing Cash Flow Coverage Ratio
Cash Flow Coverage Ratio measures a company’s ability to meet its financial obligations using its earnings. This ratio is calculated by dividing operating cash flows by total current debt. Operating cash flows, found in the statement of cash flows, include cash receipts from customers, cash paid to suppliers and employees, interest paid, and income taxes paid, all directly related to the company’s operations.
Why Track Cash Flow Coverage Ratio?
A cash flow coverage ratio greater than one indicates that a business has sufficient cash flow from operations, before taxes, to cover its debt obligations. This ratio is a critical measure of a company's financial health and is often used by financial institutions to assess creditworthiness. A higher ratio suggests less reliance on debt, offering greater opportunities for expansion without the constraints of additional debt agreements.
Interpreting the Ratio
- Greater than One: Indicates strong financial health, with enough operational cash flow to cover debt obligations.
- Less than One: Signals potential financial distress, as the business does not generate enough operational cash flow to meet its debt obligations.
Strategies to Improve Cash Flow Coverage Ratio
If your cash flow coverage ratio is less than one, consider the following strategies to improve it:
- Decrease Draws: Reduce the amount of money withdrawn from the business by owners or shareholders.
- Reduce G&A Expenses: Cut general and administrative expenses to improve net cash flow.
- Retire Debt: Pay off existing debt to reduce financial obligations.
Monitoring Cash Flow Coverage Ratio
Regularly tracking your cash flow coverage ratio helps identify trends and potential issues early. Understanding this KPI and how it is viewed by financial institutions prepares your company for successful negotiations when seeking financing opportunities.
Contact Porte Brown for more information on selecting the best KPIs for your organization.
