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Using the Cash Coverage Ratio
The cash coverage ratio is intended to measure the amount of cash available to cover payments falling due, and is therefore a measure of the solvency of a business. The cash coverage ratio is computed by adding back non-cash items such as depreciation to the net profit and dividing the result by the payments due for capital expenditures, dividends or interest and repayments on debt financing. The result should be at least 1.0 if the company is solvent. In practice, the cash coverage ratio needs to be considerably more than 1.0 because any business will have a number of payments to make from its available profits. The company will need to reward its shareholders in the form of dividends, purchase capital equipment to ensure that its plant and machinery are efficient and up-to-date, and pay taxes to the government. Some financial institutions lending to a business may look for a cash coverage ratio of more than 3.0 to ensure that the company can make interest payments and capital repayments on the loan in addition to other obligations falling due.
Short-term debt coverage may be arrived at by dividing the operating cash flow by the short-term debts falling due (including the short-term element of long-term debt). To arrive at capital expenditure coverage, the operating cash flow is divided by budgeted capital expenditure. The dividend coverage is computed by dividing the operating cash flow by planned dividend payments. To gain a clearer idea of the company's solvency, the operating cash flow could be divided by capital expenditure and dividend payments to arrive at capital expenditure and dividend coverage.
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Calculating the Ratio
Floating Steamroller Corporation intends to continue its current dividend strategy which involves paying out $80,000 in dividends per year. Any change in the dividend policy would unsettle shareholders, damage confidence in the company and send the share price down. The company is, however, concerned about its ability to meet all its other obligations and therefore wishes to compute its dividend coverage. The forecast profit in the first year is $220,000, and the depreciation taken into account in computing the profit is $20,000. If the depreciation is added back to the profit this gives operating cash flow of $240,000 to cover the dividend payments of $80,000, resulting in dividend coverage of 3.0. This would probably be regarded as an acceptable dividend coverage enabling the company to meet its dividend payments and other payments as they fall due.
In the second year, the forecast net profit is $180,000 and a depreciation charge of $20,000 is deducted in computing the profit. If the depreciation charge is added back to net profit giving operating cash flow of $200,000 to cover the dividends of $80,000, the dividend coverage is 2.5 in the second year. The ratio is therefore well above 1.0 but the company might want to look more closely at the other projected payments falling due so as to assess its ability to continue paying the same level of dividends.
In the third year, the net profit is projected to fall to $100,000, after accounting for depreciation of $20,000. After adding back depreciation there is an operating cash flow of $120,000 to cover dividends of $80,000. The dividend coverage in the third year is therefore 1.5, which although it is still above 1.0 may not be enough to give assurance to management that there will be sufficient cash available to pay the dividend and cover other payments falling due.
Based on these forecasts, management might want to look in more detail at the profit forecasts and at any other payments the company is forecast to make in these periods. They might also want to study cash flow projections that include all cash inflows and outflows over the relevant period. The results of the detailed cash flow projections would guide the management decision on dividend policy into the future.
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Advantages and Disadvantages of the Ratio
An advantage of using the cash coverage ratio is that a forecast of the financial results showing calculation of the ratio over a number of years may give assurance to management that the company will be in a position to meet capital expenditures, short-term debt or dividends. This may provide guidance on management decisions relating to capital expenditure budgeting, borrowing or dividend policy.
A disadvantage of the ratio is that it is only a rough way of testing the company's ability to cover its obligations. The accuracy of the cash coverage ratio depends on the accuracy of the forecast earnings and expenses in each year. As forecasts are projected further into the future they will tend to be less accurate and the result of computing the cash coverage ratio will be less useful in relation to later periods.
Reliance on the cash coverage ratio to make management decisions is not sufficient. The cash coverage ratio is a useful indicator that must be backed up by further analysis. A much more detailed forecast of the company’s position and forecast payments would be required to provide sufficient assurance to management that the company will continue to be solvent.