Cash Flow Adequacy Ratio: A Comprehensive Guide

What is the Cash Flow Adequacy Ratio?

The cash flow adequacy ratio definition that this metric determines if the cash flows generated by your business are sufficient to cover your recurring mandatory expenses.

Examples of these mandatory financial obligations might include:

• Your debt repayments,

• Your fixed assets purchased, and

• Issuing dividends to shareholders.

Your cash flow adequacy ratio is considered a comprehensive indicator of your business's liquidity and solvency.

Liquidity refers to your business's ability to meet short-term financial obligations, whereas solvency refers to your business's viability in meeting longer-term financial obligations.

It is considered a less risky venture for banks and other lending institutions to lend to businesses with strong operating cash flows (OCF) in their financial statements.

Cash flow adequacy ratio formula

The cash flow adequacy formula is calculated as follows:

Cash Flow Adequacy Ratio = Capital Expenditures + Debt Repayments + Dividends / Operating Cash Flow  

Typically, a higher cash flow adequacy ratio is better as it shows the company's operating cash flows can cover capex, debt payments, and dividends.

• CFA Ratio = 1.0x → Sufficient but Limited Room for Error

• CFA Ratio > 1.0x → Low Liquidity Risk

• CFA Ratio < 1.0x → High Liquidity Risk

Generally speaking, the higher your ratio (greater than 1.0), the more sustainable your business will be in covering ongoing expenses.

Whereas, if your ratio is less than 1.0, this would suggest that your business generated less cash from your operations than is needed to pay off your short-term liabilities. This signals that you have short-term liquidity problems and a need for more capital.

Cash Flow Adequacy Ratio Calculation Example

Suppose that your business has:

• An operating cash flow of $1,000,000

• Capital expenditures of $300,000,

• Debt repayments of $400,000, and

• Dividends of $100,000.

In this scenario, we'll calculate our cash flow adequacy ratio to determine our operating cash flow:  

300,000 + 400,000 + 100,000 / 1,000,000 = 1.25

Therefore, your business would need to generate 1.25 times the money needed to cover its capital expenditures, debt repayments, cash dividends, and other operating expenses.

How to calculate your cash flow adequacy ratio (step-by-step)

To calculate the cash flow adequacy ratio for your business, you will need to follow these steps:

1. Determine your operating cash flow

Assessing your cash flow adequacy starts by working out your operating cash flow (OCF).

The operating cash flow formula can be calculated by dividing your operating cash flow ratio by your current liabilities, see below:

Operating cash flow ratio = Current liabilities /operating cash flow

Your operating cash flow ratio is the cash equivalent of net income after operating expenses have been deducted. This is calculated within cash flow statements before you start any new investments or financing activities.

2. Identify your capital expenditures

Also known as CapEx, capital expenditures are the amount spent on acquiring or maintaining your fixed assets.

3. Calculate your debt repayments

This includes both principal and interest payments on debt, found in the financing activities section of the cash flow statement.  

4. Determine dividends paid

This is the total amount of dividends your business has paid to your shareholders.

5. Apply the cash flow adequacy ratio formula

Use the cash flow adequacy formula detailed above to calculate your ratio.  

The importance of cash flow adequacy

The cash flow adequacy ratio assesses a company's ability to fulfill financial commitments, indicating liquidity and solvency. It reflects the company's health and future prospects by measuring short-term and long-term financial obligations.

The cash flow adequacy ratio offers a more precise assessment of a company's financial status compared to other liquidity ratios like the current ratio or quick ratio. It considers both current and future cash flows, providing a more thorough evaluation of the company's financial health.

This metric is essential for investors and lenders to determine if a company is a good investment or lending opportunity. Analysing this ratio helps assess the company's long-term debt repayment ability and profitability, guiding resource allocation decisions for better outcomes for all involved.

It is important to remember that there are other factors to consider beyond just the cash flow adequacy ratio. Market trends, competition, and management quality are also important to investors and lenders. However, understanding a company's cash flow adequacy ratio can offer valuable insights into your financial health and growth potential.

Understanding the cash flow adequacy ratio is important for your business in a variety of ways, including:

• Greater analysis of your financial health: Alongside other important liquidity and solvency ratios, cash flow adequacy can provide a comprehensive view of your business's financial position. This will, in turn, showcase your ability to sustain operations during economic downturns or other cash flow challenges to investors. The ratio also highlights cash inflows and cash outflows, meaning you can identify problems and take proactive measures to address them before they become critical.

• A key tool for risk assessment: For investors in your business, the cash flow adequacy ratio is a key risk assessment tool. A higher ratio suggests lower financial risk, as your business can cover these obligations from your operating cash flow (OCF).  

• Better long-term financial planning: If your business is actively looking into your cash flow adequacy ratio, it means you're in a great position to make informed decisions about how you allocate your resources and manage your cash flow. For example, if you have a good cash flow adequacy ratio you may be able to consider expanding your business operations, pay down debt, or invest in new opportunities without compromising your financial stability. On the flip side, if you have a low cash flow adequacy ratio, your business can take steps to improve cash flow, such as increasing sales or reducing expenses.

• Greater confidence from investors: Your cash flow adequacy ratio can come into play during investment decisions. Investors will often make a liquidity assessment to determine businesses' financial health. If your business can demonstrate sufficient cash flow through cash flow adequacy and other key financial ratios, it will be seen as a good investment to make. Conversely, if you have a low cash flow adequacy ratio, your business may be seen as a risky venture to investors and creditors.

How can you improve your cash flow adequacy ratio?

There are a few different ways you can improve your business's cash flow adequacy ratio, such as:

• Improve your operating cash flow: Even growing, profitable businesses can be hit with issues with their cash flow. To gain enough control of your cash flow, there are several strategies you can look at implementing, including optimizing pricing, improving sales efficiency, and cutting unnecessary business costs.  

• Optimize your capital expenditures: Prioritize essential capital projects (whether this be property, technology or equipment) and defer or eliminate non-critical expenditures. Look at implementing efficient asset management practices can also reduce your capital expenditures (CapEx).  

• Manage your debt strategically: Refinancing any high-interest debt you may have, negotiating better terms, and prioritizing debt repayment can improve your ratio. Where possible, try to avoid taking on any excessive new debt.  

Cash flow adequacy ratio conclusion

The cash flow adequacy ratio is a critical measure of your business's financial stability and operational efficiency.

By regularly monitoring and striving to improve this ratio, your business can ensure you have the necessary cash flow to support growth, meet financial obligations, and maintain stakeholder confidence.

Understanding and managing cash flow adequacy is not just good practice but essential for the long-term success of your business. Don't forget that Fathom has a powerful tool for cash flow projections that helps businesses understand the impact of their plans.

Fathom automatically calculates a comprehensive range of financial KPIs, including the cash flow adequacy ratio. For more information, check out our list of default KPIs or visit our help centre. Additionally, you can explore tutorial webinars and testimonials on the Fathom blog.  

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