There are a wide range of measures and metrics used to gather information as to the financial stability and growth of an enterprise; however, the Cash Flow Coverage Ratio reflects the immediate and the long-term liquidity and sustainability of a company. In the simplest of terms, the Cash Flow Coverage Ratio identifies, in numbers, an entity’s ability to repay its debts. This ratio reveals a company’s financial health and whether or not the company is able to cover its financial obligations; this ratio also defines the number of times these obligations could be covered by the company’s earnings. In order to utilize this tool, we need to explore additional definitions and understand how to calculate these ratios.
In this example, we explore the ratio from a lender’s point of view. Lenders see the Cash Flow Coverage Ratio (CFCR) as the indicator of a Company’s liquidity and it is a vital calculation in the decision process for most Financial Institutions as to whether or not to extend or renew a loan or Line of Credit. The basic formula utilized to determine the CFCR takes the Operating Cash Flows divided by the total Debt, or Total Liabilities, as found on the Company’s Balance Sheet. From the Balance Sheet and Income Statement, the formula begins with the Net Income. To the income, add Depreciation and Amortization as expensed. The sum is then divided by the Total Liabilities. The resulting percentage will render a quick and simple measure of the financial status of the company.
Typically, any CFCR at one percent or higher indicates a strong financial position and may be considered the “Benchmark to exceed to determine a successful ratio”. Although benchmarks may differ between jurisdictions, states, markets and industries, it is a fair assumption to ascertain that any business holding assets enough to cover all debts, current and long term, is financially performing well. Under FASB Topic 820- Fair Value Measurement as amended by 2011-04, the standards for measuring Fair Market Value do not specifically support nor reject the utilization of cash flow ratios. These measures and metrics are primarily used by Financial Analysts in an out-sourced capacity, from Lenders, to potential buyers and sellers.
Now that we understand this frequently under-utilized tool, forecasting and future planning enter a new dimension to better prepare for sustainability and longevity of our enterprises. Although this is an extremely useful metric, most accounting and finance departments do not utilize it on a regular basis. As with most tools, however, unless you are aware of them, you tend not to use them.
Lorie J. Clark, CFO, has been working in the manufacturing accounting and finance area since 1996. Her accounting and financial career began in 1991 in the Mortgage Banking industry and moved into manufacturing where she found her niche. She is an experienced C-Level executive with a demonstrated history of cash flow management and is instrumental in building the financial health of the companies she works with. Skilled in Business Planning, and numerous software platforms, APICS CPIM studies and Risk Management certified, Ms. Clark focuses on all the elements of what makes a company grow and remain profitable.
Ms. Clark has earned a BAS from University of North Texas in 1986 in French and continued pursuing additional educational avenues to build her career in Accounting and Financial Management. She currently holds a Doctorate of Philosophy (Ph.D.) focused in Finance and Financial Management Services and makes a conscious effort to remain on top of any major tax or GAAP changes that could affect VSI.