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How To Better Understand The Cash Flow Of A Company

hand grab cash reach cash money dollarsA company’s ability to meet its cash flow obligation is important for the on-going concern for the company. Many companies fail not because they do not have a good business model or products. Many fail because they are caught in a situation where they do not have sufficient positive cash flow to meet its liabilities. One of the most important obligations is the interest payment on a company’s debt.

One method to understand the cash flow needed for this liability is by using coverage ratios. A coverage ratio can help an investor to understand the ability of the company to pay its interests payments from its earnings.

Interest Coverage Ratio

One of the most commonly used coverage ratios is the interest coverage ratio. It measures whether a company has enough earnings to meet its interest payment. The formula for this ratio is

Interest Coverage Ratio = Earnings Before Interest and Tax (EBIT) / Interest Expenses.

Typically, a higher interest coverage ratio means a greater ability for the company to sustain its interest payment. A company can improve this ratio by either a) increasing EBIT or b) reducing its interest expenses.

For example, if we look at the latest 2013 annual report of Noble Group (SGX: N21), it has an EBIT of USD 645.2 million while having an interest expense of USD 399.5million. Therefore, Noble Group has an interest coverage ratio of only 1.6. This suggests that Noble Group spends more than half of its earnings last year just to pay its interest cost. If there is any short fall in its business earnings, Noble Group might have a high risk of not being able to finance its debt from its earnings.

If we compare it with a company such as ComfortDelGro Corp (SGX: C52), which has an EBIT of S$ 441.7million and an interest cost of only S$27.4million, it has an interest coverage ratio of more than 16 times. In terms of ability to finance its interest expense from earnings, ComfortDelGro is in a better position than Noble Group.

Foolish Bottom Line

Most investors will not notice problems in a company’s cash flow until it is too late. As Warren Buffett like to say, “After all, you only find out who is swimming naked when the tide goes out”.  Of course, one shouldn’t only look at just the interest coverage ratio when evaluating a company.  There are other numbers and factors to consider.  However, examining the interest coverage ratio is able to give one a glimpse into the financial strength of a company.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.