Current Cash Debt Coverage

Current Cash Debt Coverage is the liquidity ratio that measures the percentage of cash flow from operating activities over the average current liabilities. It shows the ability of company to generate cash flow from operation to pay for the current liabilities. It is the company’s efficiency in managing its cash flow to cover the short-term obligation.

A higher current cash debt coverage ratio represents a better liquidity position as they are able to generate cash to pay off the current liabilities. It is a strong point to prevent company from bankrupt due to liquidation. However, there is no standard level of ratio to evaluate the performance as the businesses are different from one industry to another. For example, the trading company will be able to generate regular cash flow while the construction company may not be able to generate any cash inflow in a short time.

The cash inflow from activities is the result of business operation within the accounting period. At the same time, the business operation also incurs some liabilities which will remain at the end of the year. So if the cash flow from activities is less than current liabilities, it shows a high risk of liquidating when those liabilities reach the due date.

Current Cash Debt Coverage Ratio Formula:

Current Cash Debt Coverage Ratio = Net Cash From Operating Activities / Average Current Liabilities
  • Net Cash From Activities: is the operating cash flow from cash flow statement.
  • Average Current Liabilities: is the average amount of current liability on balance sheet.

Current Cash Debt Coverage Ratio Example

For example, base on the statement of cash flow, Company A generate $ 500,000 from business activities in 2020. The current liability on balance sheet at the end of 2019 is $ 100,000 and they increase to $ 300,000 at the end of 2020.

Average Current Liabilities = ($ 100,000 + $ 300,000)/2 = $ 200,000

Current Cash Debt Coverage Ratio = $ 500,000 / $ 200,000 = 2.5 times

It means that the company can generate more cash flow to cover the current liabilities. The company is able to use this cash to cover the debt within the current year.

Purpose of Cash Debt Coverage Ratio

  • Current Cash Ratio is used to calculate the company’s ability to generate cash to pay for its short-term liability. Cash flow is very important as the company requires to use cash to pay for employees, suppliers, and other parties. Without enough cash flow, the company can be forced to liquidate and declare bankruptcy.
  • Alert management to find other sources of funds. When the ratio falls to a dangerous level, management needs to find a new source of cash such as loan, bond, and issuing more shares. It is very important to keep an eye on this ratio otherwise it will be too late.
  • Investor uses the current cash ratio to evaluate the company’s risk. Investors need to access the risk before making any investment.
  • Creditors access the risk before providing loans. Before lending any money, they need to know if the company has the ability to pay back. Without accessing the risk, they will face with the uncollectible loan.
  • Access the company capital structure: It is very important to understand the capital structure. If company over-rely on the debt rather than equity, they need to have enough cash to pay for interest, short-term, and long-term loan.
  • Access the company liquidity’s position: It is the risk of the company going liquidate. It shows how strong the company’s financial health prevents such an issue from happening. The higher current cash ratio, the stronger financial health which company has.

Curernt Cash Debt Coverage Ratio Analysis

This ratio analyzes by using the cash from operating activities which is the main source of income, so it wants to focus on the company business only by excluding the other source of cash flow such as investing and financing. We use the current liabilities because they will be due within 12 months while the long-term liabilities may be due even in several years. The shorter time it takes to spend, the more risk for the company. They need to generate cash flow within a short period of time.

The current cash debt coverage ratio can be lower or higher than one. In theory, a good ratio should be more than one, as the company can generate more cash flow than the short-term debt. It means that business is doing well, cash flow from operating is more than enough to cover the current liabilities. However, it may differ in real life. In some industries, there are not easy to generate cash in the early day. Company needs to spend huge investment before seeing cash inflow.

Current cash debt coverage less than one is not a good sign for the business. Everyone will keep an eye on the company and they are not going to take risks to buy stock or lend the money. The business is generating cash flow less than the current liability. They need to find a new source of funds otherwise they will be forced to go bankrupt. However, it will not tell the whole story, new start-ups usually face this issue. They are relying on equity to continue their business. They are in the early stage before a business can generate enough cash flow.

Limitation of Current Cash Debt Covrage Ratio

  • Rely on the history data: The calculation of this ratio relies on the date which is at least a few weeks or even a few months old. By the time we analyze the ratio, this data is already out of date. Moreover, the future even will not always the same as the prior year. In real life, the business is changing every day. It is almost impossible to wait for such a ratio to make any decision.
  • Not practical for long-term investment: In the early stage of a long-term project, it is hard to make any prediction base on this ratio. The project will not make any significant cash flow, so the ratio will not be good.