Cash flow adequacy ratio definition
/What is the Cash Flow Adequacy Ratio?
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 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.
How to Calculate the Cash Flow Adequacy Ratio
To calculate the cash flow adequacy ratio, divide the total cash flow from operations by the sum of the long-term debt paid, fixed assets purchased, and cash dividends distributed. The formula is as follows:
Cash flow from operations ÷ (Long-term debt paid + Fixed assets purchased + Cash dividends distributed)
Any result higher than 1 indicates that a firm is generating sufficient cash flow to maintain itself without acquiring additional debt financing or equity funding.
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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