Solvency ratios are financial metrics that measure a company’s ability to meet its long-term debt obligations. They provide insights into a company’s financial strength and ability to repay debts over an extended period. Typically, solvency ratios assess the relationship between a company’s total debt and its equity or assets and indicate the proportion of debt in capital structure.
Several solvency ratios are crucial for both companies and stakeholders. One includes the current cash debt coverage ratio, an extension of the cash debt coverage ratio.
What is the Current Cash Debt Coverage Ratio?
The cash debt coverage ratio is a financial metric used to evaluate a company’s ability to repay its debt using its operating cash flow. Companies can calculate it by dividing the operating cash flow by the average total debt during a specific period. Similarly, they can extend this ratio to calculate the current cash debt coverage ratio. This ratio uses current cash and current liabilities in the formula instead.
The current cash debt coverage ratio measures how efficiently a company manages its cash resources. It gauges how much a company can cover its current liabilities using the cash it generates from its operations. Therefore, it is a crucial ratio in assessing a company’s solvency in the short term. Both investors and companies can use this ratio.
How to calculate the Current Cash Debt Coverage Ratio?
Companies can use the following formula for cash debt coverage ratio to measure their cash management efficiency.
Cash debt coverage ratio = Operating cash flow / Total debt
However, the current cash debt coverage ratio focuses on a more short-term approach. As stated above, it modifies the above formula to achieve that. Therefore, the formula for the current cash debt coverage ratio becomes:
Current cash debt coverage ratio = Current cash flow / Current liabilities
Some companies may also use the average current liabilities in the above formula. This average comes from the opening and closing balances of these liabilities.
Example
A company, Red Co., has a current cash flow of $500,000. The company had current liabilities of $200,000 at the beginning of the year and closed the balance at $300,000. Therefore, the average current liabilities for Red Co. are $250,000. Based on the above information, the current cash debt coverage ratio for Red Co. will be as follows.
Current cash debt coverage ratio = Current cash flow / Current liabilities
Current cash debt coverage ratio = $500,000 / $250,000
Current cash debt coverage ratio = 2 times
How to interpret the Current Cash Debt Coverage Ratio?
The current cash debt coverage ratio can be above or below 1. If it is the former, it means the company has more cash than its current liabilities. Usually, the higher this ratio is, the better it is for the company. It means the company has significant cash resources to cover its current liabilities. However, too high of a current cash debt coverage ratio may also imply the company is not utilizing its cash resources properly.
Similarly, if the current cash debt coverage ratio is lower than 1, the company may suffer in paying its current liabilities. It is a concern as it might indicate inefficient cash management from the company. However, users must still view this ratio comparatively to understand the acceptable current cash debt coverage ratio range.
Conclusion
The current cash debt coverage ratio measures how efficiently a company uses its cash resources. A ratio of higher than 1 implies the company can cover its current liabilities and still have some cash left. However, it is crucial to view the current cash debt coverage ratio comparatively. This ratio is one of the critical solvency ratios for both companies and investors.
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