Cash Flow Adequacy Ratio

The Cash Flow Adequacy Ratio allows financial analysts and managers to assess if expected cash flows from a project or the business are enough to meet the company's or project's operating expenses.

The ratio helps decision makers to evaluate if a project is worth pursuing or not. It does this by comparing the inflow of cash the project has to the expected or realized outflows from the project.

A ratio is a valuable tool for evaluating a current project's financial strength or viability. It can also be used to select the best project for future investment.

The expected and projected cash flows from a project can be evaluated to determine how attractive a project will prove to investors.

Many financial institutions like investment banks and venture capitalists also use this ratio to assess how much financing will be enough for a new project and how long a duration it will take to pay back project loans.

The cash flows are the primary determinant of a business’s performance, so a ratio that evaluates the adequacy of the cash flows is frequently used for credit assessment.

Uses of the Cash Flow Adequacy Ratio (CFAR)

With the CFAR, a business can evaluate a company's capacity to meet the burden of its present and long-term debts. A business that is not making enough money to meet its present (short-term) financial expenses will probably be challenged to pay for a pricier, more demanding long-term project loan.

The only exception can be if the project loans will drastically improve operating income and cash flows from operations.

Cash flows are usually very reliable as a standard for gauging financial capability. Businesses that generate enough cash from their operating cash flows to meet their short-term expenses are good candidates for longer-term loans. The cash flow adequacy ratio becomes a reliable standard for gauging credit worthiness. 

Existing lenders can also use this ratio to evaluate performance over the duration of the project to see if performance parameters are being met or matched.

The cash flow adequacy improving over time means that the firm is either raising its cash flows from operations or cutting down on its operating expenses. Both these situations make lenders happy as there is cash to pay off their loans.

Suppose the reverse is happening and cash flow adequacy is declining. In that case, it means that the business is not making enough cash from its operations to meet expenses or that expenses are rising quicker than the earnings are.

Where Not to Use the Cash Flow Adequacy Ratio

Just as the CFAR is adequate for assessing present, future and ongoing performances, it does not help in comparing different companies and different sectors.

Since every business has its unique operating structure and model, comparing two companies by using the CFAR is not a good idea.

The Formula for Cash Flow Adequacy Ratio

The CFAR matches the funds inflows with specific cash outflows. The cash outflows considered in the ratio are the business's dividends, fixed assets purchases, and long-term liability repayments.

The value of cash flows from operations can be seen in the cash flow statement. If there isn’t a cash flow statement, the cash flows from operations can be calculated from the profit and loss statement. 

The values for long-term debt repayment and purchases of fixed assets and cash dividends can be found on the balance sheet.

Reading the Results of the Calculation

If the formula gives a result above one, the cash flows are larger than the outflows, and the business is generating enough cash from its operations.

From a financing perspective, this means that the company can repay more debt from its existing operations (and may not need more debt).

If the result is less than one, this means that the firm is facing some cash flow restrictions and has problems managing its repayments and capital expenditures.

As a financial analyst for a lender, you can assume that a value of under one implies that the business needs some sort of additional cash flow financing to meet its outflows.

As a manager or analyst for the business, it means that the company needs to either reduce its cash dividends, not buy any fixed assets at present or delay its debt repayments.

The ideal cash flow adequacy ratio is either one or higher. This means that new businesses need to manage their outflows to keep their capital adequacy ratio above one.

For new businesses, a rising trend in the CFAR means that the firm is either raising its cash inflows or reducing its outflows.

The rule can also be used on for forecasting a purpose basis to assess if a financial proposal will yield a sustainable business. If not, the proposal can be amended to better the proposed CFAR.

From a lending perspective, analysts can compare cash flow adequacy ratios of different companies in the same industry and the same company for various years.

We can also compare the ratio of one firm with others in the industry to make further analyses and decisions. Even for the same company, one can compare this ratio with the past years to conclude whether the performance shows an improving trend.

An improvement is a positive measure, and a decline is a warning sign, particularly for lenders.

Conclusion

The CFAR is a helpful ratio for both internal and external analysts to measure the effectiveness of a firm’s operating cash flows and financial management of its flow of funds.

However, like any financial ratio, the CFAR has a few drawbacks which affect its application. It is not an accurate reflector of a business’s performance and needs to be used along with other performance measures like the working capital and long-term debt ratios.

Investors and lenders, in particular, need to use this ratio with other tools to make a more informed decision.

You might be also want to know about What is a Mixed Stream Cash Flow? and What is Base Case Cash Flow?