The Master Limited Partnership is a tax efficient, cash generating machine. In the MLP model, the majority of cash generated in a given period is passed directly through to investors. However, some cash is retained in order to fund future projects or growth. Understanding the difference between how much was paid out to investors and how much could have been paid out is key.
Distributable Cash Flow (DCF)
Stock investors typically use a metric called “Free Cash Flow” as a gauge of a company’s ability to generate cash (after adjusting for expenses relating to maintaining its assets). This cash can then be used to fund additional projects or pay out dividends. Similarly, MLP investors use Distributable Cash Flow (DCF) as a measure of cash available to distribute to unitholders or fund growth.
Calculating DCF is fairly simple, and involves working backward from Net Income on the Income Statement and adding back accounting related items. Remember that accounting items like depreciation and amortization are typically subtracted from income to represent the loss of value of different assets over time. However, they don’t really have anything to do with generating cash, so we want to make sure we add them back to net income. The calculation is:
The Coverage Ratio
So, now we know how to calculate Distributable Cash Flow (which represents what we could pay to investors if we wanted to). However, it’s always a smart idea to retain some of the cash generated to fund future growth or as an emergency fund. Thus, the amount actually paid out (the actual distributed amount) will typically be less than DCF. As a general rule, we like to see the ratio of DCF to the actual distribution to be greater or equal to 1.3. This ratio is referred to as the “coverage” ratio and is calculated as:
Coverage Ratio = Distributable Cash Flow / Actual Distributed Cash Flow
In our example above, if we have $225 million in DCF, we would likely actually distribute around $173 million to investors to maintain a coverage ratio of 1.3x.
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