Cash Flow Adequacy Ratio

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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

\text{CFA Ratio} = \dfrac{\text{Cash Flow from Operations}}{(\text{Long-Term Debt} + \text{Fixed Assets Purchased} + \text{Dividends Paid})}

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.

Cash Flow Adequacy Ratio Example

A paint manufacturing company, Dulux, has made and sold $300 million worth of paint last year. The cost of production of the paint was $113 million. Last year, Dulux contributed $72 million towards the reduction of long term debt. It also purchased additional new production equipment worth $33 million. 

The total money Dulux paid as dividends to shareholders was $28 million. Dulux’s management has asked its accounting department for its cash flow adequacy ratio.

Let us obtain the data from the question. We need to calculate the cash flow from operations taking the net sales ($300 million) and subtracting the cost of goods sold ($113 million)

  • Cash flow from operations = $187 million
  • Long term debt = $72 million
  • Fixed assets purchased = $33 million
  • Dividends paid = $28 million

Let’s calculate the cash flow adequacy ratio using these values in the formula (in millions):

\text{Cash Flow Adequacy Ratio} = \dfrac{187}{(72 + 33 + 28)} = 1.41

The cash flow adequacy ratio for Dulux is 1.41. Since the ratio is greater than 1, it means that Dulux is making enough money to cover for its operational expenses. This also means that if Dulux decides to take another loan, it will still be able to make contributions towards paying it.

Note that the cost of goods sold was subtracted from the net sales because operational cash flow does not include the cost of goods sold. It is the gross profit from sales.

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.

Cash Flow Adequacy Ratio Conclusion

  • Cash flow adequacy ratio is a metric that is used to determine if a company can pay for its short term expenses.
  • It is used by investors and lenders to check if a company is likely to make more profit in the future or not.
  • Cash flow adequacy ratio = cash flow from operations / (Long-term debt + fixed assets purchase + dividends paid)
  • Cash flow adequacy ratio should be used in conjunction with other metrics to determine if a company is good to invest in.

Cash Flow Adequacy Ratio Calculator

You can use the cash flow adequacy ratio calculator below to quickly calculate the cash flow adequacy ratio of a company by entering the required numbers.