Debt to FCF Ratio Explained

Most investors check a company's debt-to-equity ratio and call it a day. That's a mistake. Debt-to-equity tells you how much debt exists relative to shareholder equity, but it doesn't tell you whether the company can actually service that debt. A company can have a 'reasonable' debt-to-equity ratio and still be in trouble if it's not generating cash.

That's where debt-to-FCF comes in.

What It Measures

Debt-to-FCF is total debt divided by annual free cash flow. It answers a simple question: if the company used every dollar of free cash flow to pay down debt, how many years would it take?

Visa has $16.5 billion in debt and generates $19.4 billion in annual FCF. That's a debt-to-FCF ratio of 0.85x. Less than a year to pay off all debt if they wanted to. Public Storage carries $5.8 billion in debt against $3.9 billion in FCF. That's 1.5x. Still manageable.

Now look at the other end. Boeing has $57.9 billion in debt and burned through cash last year, giving it a negative debt-to-FCF ratio. The metric breaks entirely when FCF is negative or near zero, which is itself a warning sign.

Why It Matters More Than Debt-to-Equity

Debt-to-equity uses book value of equity, which is an accounting construct. Book value can be inflated by intangibles, distorted by buybacks, or rendered meaningless by years of losses. Free cash flow is actual cash the business generates after paying for everything it needs to keep running. You can't fudge it with accounting adjustments.

A company with high debt-to-equity but strong FCF generation can handle its debt. A company with low debt-to-equity but weak FCF is vulnerable the moment interest rates rise or revenue stumbles.

The Thresholds That Matter

At Aureus, we use debt-to-FCF as a grade modifier:

• Below 2x: upgrade territory. The company can realistically delever if needed.
• 2x to 7x: neutral zone. Manageable but not great.
• 7x to 10x: starts getting uncomfortable. One grade penalty.
• Above 10x: serious concern. Two grade penalty.
• Above 15x: major red flag. Another two grades down.

These aren't arbitrary. They're based on how much flexibility a company has when things go wrong. At 3x debt-to-FCF, a company can handle a revenue miss or a market downturn. At 12x, a single bad year becomes an existential problem.

Look at the real estate sector. Realty Income has $15.4 billion in debt and $10.6 billion in FCF. That's 1.5x, well inside comfortable range. VICI Properties sits at 4.1x. Still solid. Essex Property Trust is at 10.8x, which is why it dropped from an A to a B grade despite having a 52.5% FCF margin.

The sector context matters too. Real estate companies naturally carry more debt because their assets are tangible and stable. Technology companies have less excuse. If a software business is running debt-to-FCF above 5x, something's wrong with the business model.

When the Ratio Lies

Debt-to-FCF has blind spots. It breaks when FCF is negative, which makes it useless for analyzing turnaround situations or high-growth companies burning cash intentionally. It also doesn't distinguish between secured debt backed by assets and unsecured debt that could become a problem in bankruptcy.

It's also a snapshot. A company with 8x debt-to-FCF today but rapidly growing FCF is in better shape than a company at 6x with declining cash generation. You need to look at the trend.

Still, for profitable companies with stable operations, debt-to-FCF is the single best metric for measuring debt sustainability. Better than debt-to-equity, better than interest coverage ratios, better than credit ratings.

How to Use It

Pull up a company's latest 10-K or 10-Q. Find total debt on the balance sheet (current plus long-term). Calculate trailing twelve month FCF from the cash flow statement. Divide debt by FCF.

If the number is below 3x, debt isn't a concern. Between 3x and 7x, check whether FCF is growing or shrinking. Above 7x, you need a very good reason to own the stock. Above 10x, the burden of proof shifts entirely to the bull case.

Compare within sectors, not across them. A 5x ratio in real estate is fine. The same ratio in technology suggests the company over-levered for acquisitions or buybacks.

And remember: a company can have a great FCF margin and still fail the debt test. Essex Property Trust generates a 52.5% margin, among the highest in our entire dataset. But debt-to-FCF of 10.8x means that margin is working overtime just to service the balance sheet. That's why the grade reflects both.

FCF margin tells you how efficient the business is. Debt-to-FCF tells you whether the company can survive a bad year. You need both.