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How to Use Financial Reports to Calculate Cash Flow Coverage

Debt and the interest paid on that debt are not a company's only cash requirements on financial reports. Businesses also need cash for capital expansion to grow the company (including new plants, tools, and equipment) and pay dividends to investors.

As a shareholder, you make money only when the company's stock goes up in price. The stock market rewards a company with good growth potential by bidding up the price of its stock. Firms that show low growth prospects usually have few buyers and end up with lower stock prices.

So you want to invest in companies that not only generate enough cash to pay their bills, interest, and the principals on their long-term debts, but also have money left over to pay dividends to their shareholders and grow their company. Remember that many growth companies don't pay dividends at all, but instead reinvest all profits toward future growth.

You can test whether a company is generating enough cash to cover its capital expenditures, pay its dividends, and pay its debt obligations by calculating the cash flow coverage ratio.

How to find out the cash flow coverage ratio

You use a two-step process to calculate the cash flow coverage ratio:

  1. Calculate the company's cash requirements.

    Add the following:

    Capital expenditures (listed in the investing activities section of the cash flow statement)

    Cash dividends paid (listed in the financing activities section of the cash flow statement)

    Interest expenses (listed on the income statement)

    Current portion of long-term debt (listed in the financing activities section of the cash flow statement)

  2. Calculate the cash flow coverage ratio.

    Cash provided by operating activities ÷Cash requirements = Cash flow coverage ratio

You can find cash provided by operating activities on the statement of cash flows.

Mattel

You can use Mattel's financial statements to show you how to calculate its cash flow coverage ratio:

  1. Find Mattel's cash requirements.

    Capital expenditures$730,950,000

    Plus cash dividends paid$423,378,000

    Plus interest paid$88,524,000

    Plus current portion of long-term debt$400,000,000

    Cash requirements$1,130,950,000

    For capital expenditures, you would use two line items on the cash flow statement: Purchases of tools, dies, and molds and Purchases of other property, plant, and equipment. For current portion of long-term debt, you would use the Payments of long-term debt line item on the cash flow statement.

  2. Calculate the cash flow coverage ratio.

    $1,275,650,000 (2012 cash provided by operating activities) ÷$1,130,950,000 (Cash requirements) = 1.13 (Cash flow coverage ratio)

Mattel generated more than enough cash from its operations to pay all its cash requirements for 2012. The 1.13 cash flow coverage ratio means that Mattel generated enough cash to cover 112 percent of its cash requirements. If a company doesn't raise enough cash from operations, it must cover the rest of the cash it needs by borrowing money or drawing down cash on hand from activities in previous years.

Any firm that must draw down savings to maintain its operating activities is likely showing signs of trouble. Anytime a company can't meet its cash requirements, you want to seriously reconsider investing in it.

Hasbro

Now you can use Hasbro's financial statements to show you how to calculate its cash flow coverage ratio:

  1. Find Hasbro's cash requirements.

    Capital expenditures$112,091,000

    Plus cash dividends paid$316,503,000

    Plus interest paid$93,957,000

    Cash requirements$522,551,000

    For capital expenditures, you would use the Additions to property, plant, and equipment line item on the cash flow statement. Hasbro had no current long-term debt payments in 2012.

  2. Calculate the cash flow coverage ratio.

    $534,796,000 (2012 cash provided by operating activities) ÷$522,551,000 (Cash requirements) = 1.02 (Cash flow coverage ratio)

Hasbro generated more than enough cash from its operations to pay all its cash requirements in 2012.

What do the numbers mean?

Both Mattel and Hasbro generated enough cash from operations to pay all their bills. If a company did not generate enough cash, it would have to find sources other than operations to meet the shortfall in its cash requirements.

Companies that generate more than enough cash have a cash flow coverage ratio of more than 100 percent. The higher the ratio, the better. If you see a company that isn't able to cover its cash requirements and that has little left in cash and short-term investments, raise that red flag.

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