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 formula is:
Cash flow from operations ÷ (Long-term debt paid + Fixed assets purchased + Cash dividends distributed)
For example, 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
Any result higher than 1 indicates that a firm is generating sufficient cash flow to maintain itself without acquiring additional debt or equity funding.
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.