Cash Flow Adequacy Ratio shows the ability of the company to repay current and future debts at the expense of free cash flow. It is used to determine a credit rating of corporations.
Alternative names of Cash Flow Adequacy Ratio:
- Cash Flow Adequacy Ratio.
What Does Cash Flow Adequacy Ratio Show?
Cash Flow Adequacy Ratio is determined as the ratio of net free cash flow to the average annual value of debt for the future periods. This average annual amount of debt payments helps to smooth the uneven payments of a principal debt. The coefficient is widely used by rating agencies to assess the credit rating of corporations.
Formula of Cash Flow Adequacy Ratio
CFAR = Net Free Cash Flow / Average annual payments for the next several years
Net free cash flow (or the residual cash flow) includes the expenses for the renewal of fixed capital, payments of interest and dividends.
Normative Value of Cash Flow Adequacy Ratio
Normative value of the coefficient is determined separately for each company. The higher the value of the metric, the easier the company will cope with its financial burden. If the indicator’s value exceeds 1, the enterprise can fully finance its own needs. If the coefficient is below 1, it is likely the internal sources will not be enough to finance the necessary expenses.