Current Cash Debt Coverage Ratio is categorized as a liquidity ratio that is used to measure the effectiveness with which cash is managed within the company.
It basically is a metric that depicts the company’s relation to the operating cash flow that is received by the company over the respective period, along with the current liabilities that needs to be settled by the company.
In simpler terminology, it basically reflects the company’s ability to settle its current liabilities from the operating cycle over the respective period.
Current Cash Debt Coverage Ratio is calculated using the following formula:
Current Cash Debt Coverage Ratio = (Net Cash provided by Operating Activities) / (Average Current Liabilities)
How to Calculate Current Debt Coverage Ratio?
The calculation of Current Debt Coverage Ratio can be explained using the following illustration:
Jardin Co. was able to generate $26,250 from its operating cycle in the Financial Year ended Dec 31 2019. Jardin Co. had current liabilities of $20000 and $30000, on 1st January 2019, and 31st December 2019, respectively.
In the illustration given above, the Current Debt Coverage Ratio of Jardin Co. can be calculated as follows:
Current Cash Debt Coverage Ratio = 26250 / (Average Current Liabilities), where
Average Current Liabilities = (20,000 + 30,000) / 2 = $25,000. Therefore,
Current Cash Debt Coverage Ratio = 26,250/ 25,000 = 2
Interpretation: The Current Cash Debt Coverage Ratio of 1.05 means that for every $1 of Current Liability that the company has, it also has $1.05 from its Operating Cycle to fund that particular Current Liability.
A high Current Cash Debt Coverage Ratio is indicative of a better liquidity position of the company. Generally, a Current Cash Debt Coverage Ratio of 1:1 (or higher) is considered as very comfortable from the standpoint of the company.
Current Cash Debt Coverage Ratio tends to be a highly important metric that helps companies, as well as their stakeholders in the decision-making process. Here are a few reasons why this particular ratio is considered to be a really important ratio:
- Current Cash Debt Coverage Ratio includes thee holistic performance of the year, because it includes the amount that has been raised from Operating Cycle of the company across the year. In the same manner, it incorporates ‘average liabilities’ across the year, which means it inculcates the holistic performance of the company and not just standalone figures.
- This ratio also allows the investors of the company to identify the standing of the company, and how likely is it that they will get dividends on time, and the company is not going to face a liquidity issue. This ratio can be a very quick source to extrapolate the future liquidity position of the company.
Regardless of the usefulness of the Current Cash Debt Coverage Ratio, it can also be seen that there are a couple of drawbacks and disadvantages associated with this particular ratio. They mainly include the following:
- This ratio calculates the ability of the company to be able to pay their current liabilities based on the amount generated from the operating cycle. However, it ignores the fact that average liabilities, as well as incomings from operating cycle are not spread evenly across the year. It gives a generic idea, which cannot be considered concrete in terms of absolute surety that the company will not face a liquidity issue in the coming years.
- In the same manner, Current Cash Debt Coverage Ratio fails to incorporate the fact that there are other expenses and obligations (which are non-current liabilities), that the business has to honor. It is also important to ensure that those particular cash flows are incorporated. Therefore, this particular ratio cannot be relied upon in isolation.
How can Current Cash Debt Coverage Ratio be improved?
Current Cash Debt Coverage Ratio is considered to be a very important ratio, and hence companies should actively make an effort to improve this ratio. This can be done using either of the following:
- The easiest way to increase this ratio is to increase the net operating income. This can either be done by increasing sales, or reducing the expenses. By increasing the net operating income, the funds that the company would have at their disposal are likely to increase, hereby resulting in a better current cash coverage ratio.
- Paying off existing debts can also improve the Current Cash Debt Ratio, since this would directly reduce the liabilities of the company at the given time.
- Decreasing the amount that the company borrows can also positively impact the Current Cash Debt Ratio, because this is the amount that would directly impact the liabilities of the business, hence improving the ratio.