26 January 2008

A Small Cash Management Scoring Change Involving Debt and Cash Flow

In May 2007, we added the following three metrics to the set that determine the Cash Management gauge score:
In this post, we are going to discuss the second metric: Debt/CFO, which is expressed in years. For example, a company may have short- and long-term debt that equals 2.5 years of Cash Flow from Operations. Higher durations indicate greater leverage in the company's capital structure, giving a different perspective than the more common LTD/Equity ratio (which we also consider). In a healthy company, debt payments are typically made out of future cash flows. If the cash flow isn't sufficient, the company might have to take on more debt (probably on more onerous terms) or sell otherwise productive assets.

For computing the Cash Management gauge score, our approach had been to give points for year-to-year reductions in the Debt/CFO ratio. This approach inadvertently penalized companies have little or no debt. If the debt level is low (e.g., one year of Cash Flow), then there is no need to be concerned with whether the level is static or declining.

Therefore, we have altered the scoring to reward low Debt/CFO ratios. We will still give credit for debt reductions, but it won't be the entire focus of the score.

The new scoring will be put into effect immediately. Previous scores will recalculated as they are needed for new analyses. The effects are not expected to be significant for most companies.

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