What Are the Advantages of the Current Cash Debt Coverage Ratio?
The primary advantage of the current cash debt coverage ratio is that it reveals a company's ability to meet its current debt obligations. It is found by taking a company's cash flow from operations and dividing it by current liabilities. Secondary advantages of the ratio include the fact that it measures liquidity based on the beginning and ending of a fiscal year and is more accurate at predicting a company's ability to pay its financial obligations.
Companies need a net positive cash flow from sales operations in order to survive. In the short-term, a lack of adequate liquidity can force a business to borrow more than it is capable of repaying or sell off assets in order to shrink, rather than expand operations. The current cash debt coverage ratio reflects how many times a company would be able to repay its current liabilities from its current net cash flow. This is an advantage to investors who need an accurate picture of a company's financial position.
Investors often look at whether a company has financial promise since buying stock, bonds or giving a substantial private investment carries the risk of not seeing a future return. The current cash debt coverage ratio is a way to get a quick snapshot of a firm's ability to fund its own existence, without having to examine and interpret pages of detailed financial statements. A low or negative ratio can indicate problems with a firm's strategy or market acceptance of its products and services. Since investors are owed future payments in the form of dividends or a lump sum when they sell their stocks and bonds, a solid current cash debt coverage ratio is a good indicator that they will be paid.
Another advantage of the ratio is that it shows the company's current ability to meet its debts. It shows how much cash flow a company generated relative to the amount of liability payments it needed to meet. This can benefit investors since they may sell their stake in the company at any time. The ratio can provide a greater level of accuracy as it isolates the cash received from operations during the past year and the amount of regular debt payments incurred from loans, orders from vendors, and maintaining property and equipment.
A healthy current cash debt coverage ratio should reflect a higher number on the left side, which represents cash, or at least a number that matches the number on the right side, which represents debt. The benchmark for a company with adequate liquidity is often 1:1. Depending upon the company's industry, what is considered an acceptable figure may vary. Some industries average a higher net cash flow relative to debt than others, such as those with an online selling platform, as these businesses typically incur low overhead costs.
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