What is the Cash Flow Adequacy Ratio?
The cash flow adequacy ratio is used to determine if the cash flow generated by a company is sufficient to pay for its ongoing expenses—for example, reductions in long-term debt, acquisition of fixed assets or paying dividends to shareholders.
Cash flow adequacy is a liquidity ratio that measures the ability of a company to meet its short term cash expenses.
With cash flow adequacy ratio, lenders can determine the ability of a company to pay its current debts and future ones as well. A company that is unable to meet its current financial expenses will find it difficult to pay for an additional loan, except the loan is used to exceptionally boost the cash flow from operations.
On the other hand, companies who can fund their current short term expenses from operational cash flows are more likely to pay back their debt. The cash flow adequacy ratio is hence used to determine a credit rating for companies.
Companies may also use the cash flow adequacy ratio for different years to compare their performance. If the cash flow adequacy ratio is increasing over the years, it is a sign that the company is increasing its operational cash flow or reducing its expenses.
However, if the cash flow adequacy ratio is decreasing, it is a sign that the company is increasing its expenses, or losing its cash flow from operations.
While the cash flow adequacy ratio is good for comparing a company’s current and previous performances, it is not advisable to use the cash flow adequacy ratio to compare companies that are in different industries, since their operational models will not be the same.
Cash Flow Adequacy Ratio Formula
The cash flow adequacy ratio is used to determine whether the cash flows generated by the operations of a business are sufficient to pay for its other ongoing expenses. In essence, cash flows from operations are compared to the payments made for long-term debt reductions, fixed asset acquisitions, and dividends to shareholders. The formula is:
Cash Flow Adequacy Ratio = Cash flow from operations ÷ (Long-term debt paid + Fixed assets purchased + Cash dividends distributed)
The cash flow from operations is the income of the company from the sale of its products and services. Cash flow from operations is different from net income because net income in a year will also include any extra cash that the company makes in the period, such as one time sales of old equipment or real estate. Cash flow from operations can be obtained from the sales records or calculated. Note also that it does not include the cost of goods sold.
Long-time debt is the money that the company is owing and is supposed to pay back over a long period. There will be typically yearly or monthly contributions towards offsetting the loan.
Fixed assets purchased are the capital expenditures such as new production equipment, purchase of landed property, etc., that will be used to increase production.
From the equation, the cash flow adequacy ratio will increase if the cash flow from operations increases, and it will decrease if the denominator of the equation, which is the long term debt plus fixed assets purchased plus dividends paid is increased.
Any result higher than 1 indicates that a firm is generating sufficient cash flow to maintain itself without acquiring additional debt or equity funding.
The concept can also be applied on a forward-looking basis to determine whether a financial plan will result in a self-sustaining enterprise. If not, the plan can be adjusted to improve the planned cash flow adequacy ratio.
Example of the Cash Flow Adequacy Ratio
A business generates $500,000 of cash flows from operations in its most recent year of operations. During that time, it also paid down $225,000 of debt, acquired $175,000 of fixed assets, and paid out $75,000 of dividends. Its cash flow adequacy ratio is calculated as:
$500,000 Cash flow from operations ÷ ($225,000 Debt payments + $175,000 Fixed asset purchases + $75,000 Dividends) = 1.05 Cash flow adequacy ratio
Cash Flow Adequacy Ratio Analysis
The cash flow adequacy ratio is used to determine if a company is generating enough cash to support its short-term expenses. This same principle is used to estimate the viability of future loans or other projects. In this case, the terms of the equation are replaced with future values and the ratio is calculated.
The value of the cash flow adequacy ratio will inform if the plan is sustainable, else, the values can be adjusted to increase the cash flow adequacy ratio.
A cash flow adequacy ratio of 1 or greater is an indication that the company is generating enough cash to cover for its expenses. A cash flow adequacy ratio of less than one means that the company is unable to generate enough cash to cover its short-term expenses.
Investors can monitor the cash flow adequacy ratios of a company over time to see it is increasing or decreasing, before deciding to invest in the company. However, cash flow adequacy ratio should not be the only ratio that should be used as it does not consider other important aspects of a company like its assets.
Cautions & Further Explanation
On its own this ratio provides little insight to the full performance of a company and does not include factors that would have a big effect on the future of a business such as its working capital.
As such, this ratio has its limitations and as an investor, you would be inclined to perform a full analysis of all areas of the business before deciding whether to invest.
Investors can track the cash flow adequacy ratio of past years and current years to analyze if a company is worth investing in or not. Even though the ratio is very useful, it suffers from one major drawback. One can not solely rely on this ratio to assess the full performance of a firm. Moreover, this ratio does not consider other factors that may impact the company’s future performance, such as the working capital. Thus, an investor is recommended to take the help of other tools to evaluate the company’s performance. Nonetheless, this ratio is important and needs to be considered when making any investment decision.