A Chinese proverb says the timely return of a loan makes it easier for you to borrow a second time. No one likes to be indebted, but sometimes we do not have a choice. If you like borrowing from financial lenders, you must have noticed that they ask for a business plan for a new business, or you have been in operation, financial statements. With these financial records, banks will easily notice whether you are a good candidate for a financial loan or not. Among the many things they check is the ability to repay a loan, and something criterion used is the cash-debt coverage ratio. So, what is this ratio, and how will it determine your loan eligibility? Let's let you know more.
Cash Debt Coverage Ratio
According to Corporate Finance Institute, the cash debt coverage ratio can also be referred to as the cash flow to debt ratio. It's also known as the current cash debt coverage ratio. It measures a company's ability to repay its debts by comparing the money flow received from operations to the total liabilities.
The formula, therefore, entails dividing operating income by total liabilities. It is usually expressed as a percentage such that if you get the result as 0.20, this means the ratio is 20%. Alternatively, it's interpreted that for every dollar of total liabilities, 0.2 cents was obtained from operating activities. The 20% obtained implies that the company will pay off 20% of their outstanding debts in one year. However, it can also be expressed in years by dividing the end result by 1. Therefore, if you have a cash debt coverage ratio of 0.2, when divided by 1, the resulting figure is 5, and therefore it would take the company Five years to repay all its debts.
The ideal ratio is 1:1 since it means that the net cash from operating activities can cover the entire liabilities. Even if it does not become 1, a high ratio is favorable to creditors since it shows your ability to repay your loans is excellent. A low ratio indicates future financial hurdles that the company may not overcome and cannot service its debts. However, as Investing for novices explains, even highly indebted companies will have a promising future so long as market conditions remain favorable. Therefore, even when your company scores a low cash debt coverage ratio, the lender can still offer you a loan considering other factors.
It Should Not be Confused with Debt Service Coverage Ratio
As described, the money debt coverage ratio formula is: operating cash flow/total business debts. One can easily mistake it for the debt service coverage ratio (DSCR), whose formula is: net operating income/ annual debt payments. Although both are used to assess the ability to repay its loans, your debt service coverage ratio is specifically accustomed to gauge how the cash flow can meet the obligation within one year. Annual debt payments mean any debt obligations that must be repaid within a year. Capital with Strategy further clarifies that the ratio is not just applicable to companies; its creditors also use it on unique projects and borrowers.
In some cases, the taxes, interest payments, and depreciation are removed from the net income to get the net income in the end expenditures. However, the formula can nonetheless be tweaked a little to have the interest expense put into the principal payments as detailed in Investopedia. The formula shows your debt service coverage ratio as net gain divided by principal repayments plus interest expense. Another distinction between the DSCR and the cash debt coverage ratio is the interpretation of the resulting figures. While using the cash debt coverage ratio, the perfect result is 1, in the DSCR, the best outcome is greater than one. If it is less than one, it is negative, meaning that you have a negative cash flow, and you are thus bringing in less revenue than what you are spending on borrowing expenses. If it's greater than one, you can comfortably pay off your debts. The ideal ratio of DSCR is 2 for anyone looking to take on more debt.
Importance of Calculating Solvency Ratios
Solvency should not be confused with liquidity; while solvency assesses its ability to repay long-term debts, liquidity evaluates its capacity to meet short-term obligations. Both ratios are, however, important to creditors to gauge the financial health of the company. So you do not have to wait until you are applying for a loan for a creditor to tell you if the clients are heading in the right direction.
According to Quickbooks, besides facilitating your creditworthiness, regularly calculating solvency helps to evaluate the capital structure and determine if it is necessary to redistribute internal and external equities. Furthermore, you may feel like you need a loan, however the solvency ratio indicates otherwise. However, before you take on more obligations, always compare your company's ratios with other competitors in the industry. As the article enlightens us, utility companies usually have lower solvency ratios than technology firms.
Also, ensure that you maintain records over many years to observe any particular trend. Sometimes, there could be circumstances beyond your control that resulted in an undesirable ratio. Regardless, regularly checking the ratio helps to see if the financial is improving or getting worse to facilitate a more informed decision. To get a truth of the firm's solvency, you can use other ratios that include debt to equity ratios, interest coverage ratio, asset coverage ratio, amongst others. The main thing is knowing how to interpret whichever ratio you use and still pay attention to the industry in which you are operating. For instance, to have an asset coverage ratio, a utility company is expected to have at least 1.5, while a commercial firm should have at least 2.