Cash Flow Metrics: Part 3 – Coverage Ratios

Not every metric you analyze has to deal with intrinsic value, potential upside, or profits. When evaluating a potential investment ask yourself, can the company cover their debt? Will they be able to sustain and increase cash dividends? It’s always a good idea to play devil’s advocate and force yourself to check and make sure a company can cover its obligations. And what better way to check than by using cash flow?

Coverage Ratios, Cash Flow Metrics, Interest Coverage
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Cash Flow To Debt

The debt to equity ratio is great, but using operating cash flow, or FCF, as a numerator gives you a better understanding if the company can cover its short or long-term debts in the immediate future.

 Calculations:

  • OCF / Short-Term Debt
  • OCF / Long-Term Debt

Debt is not always a bad thing, you just want to make sure the firm is utilizing it in a responsible, or advantageous to shareholders, way. If a company is using debt to primarily fund business operations, more than likely it’s a business model you want to avoid. A good way to verify against this is by using cash from operations in the numerator.

  • Apple: 63,173 / 15,996 = 3.95
  • Apple: 63,173 / 68,939 = 0.92

Coverage Ratios, Cash Flow Metrics, Interest Coverage

Coverage Ratios, Cash Flow Metrics, Interest Coverage

Obviously, the higher the number better, but if a company has coverage ratios below 1 for an extended period of time then it shows they’re having a hard time generating enough cash to cover their debts and the business is probably in trouble. Apple’s current numbers look great for the short-term, but their long-term debt has been steadily increasing.

Alternatives:

  • FCF / Short-Term Debt
  • FCF / Long-Term Debt

Interest Coverage

Typically anytime a company borrows money in the form of debt they must pay interest on said debt. The interest coverage ratio measures a firm’s ability to meet these obligations with core business cash flow.

Coverage Ratios, Cash Flow Metrics, Interest Coverage

Calculation = OCF / Interest Expense

A business taking on too much of a debt load will have a low multiple here, while company’s that are generating strong cash from operations will have a high one.

  • Apple: 63,173 / 1,244 = 50.78

There is no ideal number, but generally a number greater than 3 is preferred. This indicates the firm generates more than 3 times in operating cash flow than their current interest payments. While Apple’s long-term debt has been rising, you can see they currently have no trouble paying interest on the current debt load.


Modified Dividend Payout Ratio

The modified dividend payout ratio is an indicator of how well free cash flow supports the current dividends paid.

Coverage Ratios, Cash Flow Metrics, Interest Coverage

Calculation = Cash Dividends / FCF

If you prefer investing in dividend stocks, or even if you don’t for that matter, this metric is a must to analyze. After all, investors in dividend-paying stocks very much want to see consistent, if not increasing, dividend payments. The price fluctuations of these stocks will reflect this so before you invest in a dividend-paying stock and get burned, check this ratio out.

The main concern with these stocks is can the company keep the current level of dividends consistent and possibly increase them over the years? And since dividends are paid with cash, not earnings, you need to check by using a cash flow number as the denominator. If you want to ensure the company can sustain and increase dividend payments, then I recommend using free cash flow.

Apple:  12,022 / 50,005 = 24.04%

Again, there isn’t an ideal number you’re looking for, but to be safe I want to see a payout ratio no more than 50% and preferably much less. Using Apple as an example again, you see they could increase their dividend payments substantially without breaking the bank.


Summary

I hope you have enjoyed this series on cash flow metrics and please check out part 1 and part 2 if you missed them.