Cash Flow Adequacy Ratio

Cash flow adequacy ratio measures if cash flows generated from operating activities in a period are sufficient to pay off fixed asset purchases, made the payments due on debt and pay dividends. A cash flow of 1 or higher means that the company is able to meets its most pressing cash flow demands.

Cash flow adequacy ratio is principally a liquidity ratio because it measures the ability of a corporation to meet its cash outflow requirements from investing and financing activities using cash flows from operations. If the cash flow adequacy ratio is lower than 1, it means that the company might have to borrow short-term to meet its requirements or cut down its fixed assets spending or dividends.

Cash flow adequacy ratio is different from the cash ratio which compares cash and cash equivalents with current liabilities.

Formula

The cash flow adequacy ratio is calculated by dividing the cash flows from operating activities by the sum of routine fixed asset purchases, debt repayments and dividends to be paid:

$$ Cash\ flow\ adequacy\ ratio=\frac{CFO}{Capex+Debt+Dividends} $$

Where CFO is the cash flows from operations for the period (say year), Capex represents the fixed assets purchases that are expected to be meet during the period, Debt stands for total of debt repayments to be made during the next period and dividends are the dividends either declared by the company or expected by the shareholders considering the company’s dividend history.

Example

The following tables shows calculation of the cash flow adequacy ratio and the current ratio for General Electric based on its financial statements for the last 5 years:

USD in million Calculation 2013 2014 2015 2016 2017
Cash flow from operations CFO 28,579 27,710 19,891 (244) 10,426
Investments in PPE C1 13,458 13,727 7,309 7,199 7,371
Purchases of intangibles C2 - - - - 549
Debt repayment Dt 75,691 59,492 71,497 59,903 25,622
Dividend paid D 7,821 8,851 9,295 8,806 8,650
Current assets CA 424,692 420,487 294,596 173,619 155,148
Current liabilities CL 171,159 190,544 155,543 86,811 81,425
Cash flow adequacy ratio CFO/(C1+C2+Dt+D) 0.29 0.34 0.23 (0.00) 0.25
Current ratio CR = CA/CL 2.48 2.21 1.89 2.00 1.91

The cash flow adequacy ratio has stayed in the range of 0.23-0.34 during four of the five years. There is a significant mismatch between the current ratio and the cash flow adequacy ratio. It is because current ratio compares current assets with current liabilities, but cash flow adequacy ratio compares the cash flow from operations (CFO), a current measure with capital expenditure and debt repaid, which are predominantly non-current in nature.

A cash flow adequacy ratio of less than 1 means that the company must either liquidate its investments or obtain additional equity or debt financing to meets its capital expenditures, debt repayment and dividend policy obligation.

Written by Obaidullah Jan, ACA, CFA and last modified on