Cash flow to debt service ratio is the improvement in interest coverage ratio. In interest coverage ratio, we create relationship between net profit and total interest payment but we all know that interest payment will always in cash form. So, it will be better if we create relationship between cash flow from operation instead of net profit and total interest payment. Following is the formula of cash flow to debt service ratio.
In this formula, we are seeing that there is relationship between cash inflow from operation and total interest payment. More high will our cash flow before interest, depreciation and taxes, more we can easily pay our interest without any problem.
What is sinking fund Appropriation on Debt?
Sinking fund is just like a reserve fund which is used for repayment of loan. So, this fund is also created from our profit for repayment of loan. This fund will be specific rate on our taken debt. So, we will add this total interest payment when we calculate cash flow to debt service ratio.
Calculate cash to debt service ratio :
Net profit after tax = 22500
Fixed interest charges = 2000
Depreciation charged = 3000
Tax rate = 50%
Sinking fund appropriation = 7.5% of outstanding debentures
10% debentures = 20000
Debt cash flow coverage ratio or cash flow to debt service ratio =
CF/ 1 + SFD / 1 - T
= 22500 + 22500 ( tax ) + 2000 ( interest ) + 3000 ( Depreciation ) / 2000 + 1500 / 1- 50%
= 50000 / 2000 + 1500 / 0.5
= 50000 /5000 = 10 times
It means we have 10 times cash from our profit which is available for paying interest. In other words, we have cash profit for paying interest on the debt of 200,000.
Importance of Cash Flow to Debt Service Ratio
To calculate this ratio is very important for creditor because our creditor will think 100 times before giving us loan. If he see, we have 10 times cash profit for paying his interest on loan, he will ready to give us more loan. If this cash flow to debt service ratio will be 20 times, other creditors will also be ready to give us loan. If our cash flow to debt service is just 1 or 2 times, our creditors can say us good bye, when we will ask for loan.