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QuestionsCategory: Financials QuadrantDebt Ratios and Flow ratio
Jieren Zheng asked 5 years ago

Hi guys,
I was wondering, what is the difference between these ratios:

  • Debt-to-Cashflow ratios
  • Debt servicing ratio

Also, I noticed Motley Fool has this Flow Ratio:
Flow Ratio = (Current assets-Cash) / (Current liabilities-short-term debt)
 
How useful would it be to add into our analysis of their financials?

9 Answers
Victor Chng answered 5 years ago

Hi Jieren,
 
Debt to Cash flow ratio use the total debt while the debt servicing ratio use the net interest expense. Hence the numerator of both ratio are totally different. 
 
As for the flow ratio, this is my first time seeing it so I can’t comment much on it.
 
Based on my personally experience, all the debt ratio will point out to the same outcome hence you should not be using too many debt ratio to analyse the business as it my over complicate things. My advise is to stick with maximum two debt ratio.

Jieren Zheng answered 5 years ago

Hi Victor,
Thank you so much for your reply!
Which would you recommend as a better gauge between the two? And if you don’t mind, why one over the other? (just for learning purposes)
The flow ratio is supposed to gauge how well the company is utilising their money (http://wiki.fool.com/Foolish_Flow_Ratio), seems an interesting idea for discussion sake, though it’s actual usefulness I’m not too sure.

Victor Chng answered 5 years ago

Hi Jieren,  
 
In the past I only use total debt to equity ratio but as times goes I realised some companies can make use of debt to grow their business and so in order not to miss out this type of companies I uses the debt to cash flow ratio as an add on to the total debt to equity ratio. When we were teaching dividend machines we do not want to complicate things too much for the investor hence we created the debt servicing ratio for the income investor for easy reference. If I would to choose two debt ratio to use for the investment quadrant type of companies, I will still use total debt to equity and debt to cash flow ratio as a gauge.  
 
In my early stage as an investor, I love to keep increase the number of ratios in my excel template so I does not miss anythings. As I grew more savvy into the investing game, I realised sometime too many ratio can complicate things and most of the time the new ratio are similar to the old one. For instance, the objective of the flow ratio by the fool is stated as below:  
 

Putting it all together The lower the Flowie, the better. A number of less than 1.25 is pretty good. Below 1.0 means that the business is able to delay more payments than it’s carrying in costs of inventory and unpaid bills.

 
The objective stated by the fool ratio is exactly the same as the objective of cash conversion cycle. Hence, personally I felt adding this ratio into your analysis will complicate things because both ratio reflect the same objective. 

Jieren Zheng answered 5 years ago

Hi Victor,
Thank you so much for your insights! I tried reading investopedia and seems like more or less the debt ratios should show similiar stuff, thus I asked one over another.
Ah, the flow ratio, I thought it was closer to a liquidity ratio than a cash conversion cycle, thanks!
Agreed, I tabulate my own numbers into a spreadsheet as well. I am trying to keep it comprehensive yet not overwhelming that it overlaps (which becomes an extra and not useful number), to avoid complicating things :)
Thank you so much again! :D

Victor Chng answered 5 years ago

 Hi Jieren,
 
I don;t think the flow ratio is a liquidity ratio because their definition is that is the ratio is below one, the business is able to delay more payments than it’s carrying in costs of inventory and unpaid bills. Which means in order for this ratio to show desirable result the denominator have to be more than the numerator. Hence, the liability part will be more than than the asset part. In the case for liquidity ratio, the ideal one is when asset exceed the liability. 
 
Their definition explain the delay more payment than it’s carrying in costs of inventory and unpaid bills seem to be closely related to the cash conversion ratio (CCC). Negative cash conversion ratio result in the company delay payment to supplier and use it to finance their working capital.
 

it’s all about the cash: An increase in a current liability like accounts payable results in an increase in operating cash flow, while an increase in a current asset like accounts receivable results in a decrease in operating cash flow. 

This sentence further talk about the cash flow of the business which link to the flow ratio which is also similar to the CCC because business with negative CCC usually have very strong cash flow.

Jieren Zheng answered 5 years ago

Ah, I see! Thank you so much! That explains it much better! (Man, I really suck at interpreting numbers ^^”)

Victor Chng answered 5 years ago

Hi Jieren,
 
No one is good at interpreting the numbers at the start, I am also once suck at it. The most important thing is to keep learning and gain experience from there. 
 
Keep up the good work. If you have anymore questions feel free to ask :)

Jieren Zheng answered 5 years ago

Thanks for the encouragement! :D Will do :)

Josh answered 5 years ago

Hey guys,
Net operating asset came to mind when I saw the Foolish Flow ratio. Seems to be a twist and name play but checking on the same thing, only varying in timeframe. NOA covers Current & Non-Current while FFR checks only on the current (1yr) condition of the company.
“Net operating assets are those assets of a business directly related to its operations, minus all liabilities directly related to its operations.” The equation is:
Net Operating Asset = Operating assets – Operating liabilities
Where:

  • Operating assets = total assets – cash
  • Operating liabilities = total liabilities – total debt

“This relationship shows the income generated from operations, as a percentage of the net assets used to create that profit. Conversely, the measurement strips out all earnings related to financial activities, so that returns based on leverage are ignored. In short, the net operating assets concept is intended to reveal the relationship between core earnings and core net assets, ignoring all financial engineering”
https://en.wikipedia.org/wiki/Net_operating_assets
http://www.accountingtools.com/questions-and-answers/net-operating-assets-definition-and-usage.html
 
Reverse engineering the NOA, OA & OL:

  • Current Operating assets = Current assets – cash
  • Current Operating liabilities = Current liabilities – Current (aka S.T.) debt

And instead of using Operating assets to deduct Operating liabilities, Rex Moore made it into a ratio for quick analysis by arriving at the foolish flow ratio.
Flow Ratio = (Current assets – Cash) / (Current liabilities – Short-Term debt)
“Putting it all together The lower the Flowie, the better. A number of less than 1.25 is pretty good. Below 1.0 means that the business is able to delay more payments than it’s carrying in costs of inventory and unpaid bills.”
Rex Moore is quite amazing. Similar to current ratio but the key is removing financial leverage & non-working assets (cash).
Cheers,
Josh
 
 

Jieren Zheng replied 5 years ago

Now I’m confused @_@

Josh replied 5 years ago

Haha. =P

Like Victor mentioned, good to have but what we have learnt from the webinars is enough.

Jieren Zheng replied 5 years ago

Yea, I’ve skipped the ratio. Added stuff like FCF yield and earnings yield for myself though :)

Josh replied 5 years ago

Just to “poke the box” and relief my OCD.
Found another link which explains it better. Think the more proper name for the foolish flow would be the “operating working capital ratio”. http://xplaind.com/772531/net-operating-working-capital

Jieren Zheng replied 5 years ago

Thanks for the read :)