A reader recently asked about debt to cash flow ratios when analyzing a stock, but before addressing this question, perhaps it is best to start by defining this main element of fundamental analysis.

Debt to cash flow ratio – better known as debt ratio – is a comparison of a company’s operating cash flow to its total debt. The purpose of this ratio is to estimate a company’s ability to cover total debt with its annual cash flow from operating activities.

Now let’s look at the reader’s question and frame the answer in real-world terms. The reader indicated (in part):

“There was an analyst on TV and they are to blame for the cash flow ratio of two companies. With the first company, they stated that their cash flow debt is 17 times that is really off the charts. Normally at this time in the cycle, cash flow is about 2 times.

## Two problems

There are two problems here and neither is the fault of the reader.

The first problem is that there are numerous ratios that look a debt and the ability of a company to pay its obligations.

These are important considerations because a company that is having trouble paying off its debts is heading for the trouble and is probably not a stock you want to own.

The ratios that look at this aspect of a company’s finances are generally referred to as coverage ratios.

The second problem is that the formulas for the financial ratios are not necessarily set in stone. Some analysts apply formulas to take into account various factors.

## Hard to know

In this case, it is hard to know what the analyst was using a formula. Debt to money ratio normally results in a percentage. It is often calculated in this way:

Cash flow debt ratio = operational cash flow / total debt

For example, a company with \$ 15 of operating cash flow and \$ 21 billion in debt have a cash flow debt ratio of 71%.

Normally you want to see this ratio of more than 66% – the higher the better. However, this ratio is more useful when placed in the context. First, how has the ratio changed in the last five years or more? Is it getting higher or lower? Secondly, what are the relationships for other companies in the same sector? Some capital-intensive industries may have a lower cash-flow debt ratio than in other sectors. You can find the numbers to calculate cash flow debt ratio on a company’s financial statements.

Operational cash flow is on the cash flow statement and the debt on the balance sheet. You will want to be careful with companies with a low cash flow debt ratio. Especially in difficult economic times, cash flow can suffer, but the debt does not go down. The greater the ratio, the better a company returns to rough economic conditions.