Cash Flow to Fixed Asset Requirements Ratio
The term cash flow to fixed assets requirements ratio refers to a metric that allows the investor-analyst to understand if a company can fund fixed assets with internally generated sources of cash. If the calculated ratio is less than 1.0, then the company will have either have to lower its planned purchase of fixed assets or seek funding from external sources.
Cash Flow to Fixed Asset Requirements Ratio = Cash / Planned Purchase of Fixed Assets
- Cash is equal to net income plus non-cash expenses (such as depreciation and amortization) minus non-cash sales.
Cash flow measures allow the investor-analyst to understand if the company is generating enough cash flow from ongoing operations to keep the company in a financially sound position over the long term. One of the ways to understand the ability of a company to fund its planned purchase of fixed assets is by calculating its cash flow to fixed assets requirements ratio.
By calculating a company’s cash flow to fixed assets requirement ratio, the investor-analyst can understand if the company’s cash flow is sufficient to fund its planned purchase of fixed assets. If the ratio is greater than 1.0, then the company’s projected cash flow would be sufficient to fund these purchases. If the ratio falls below 1.0, then the company has the option of purchasing fewer fixed assets (lowering the dollar value of the planned purchases) or the company can seek external sources of cash to fund their planned purchases.
When using historical projections to forecast cash flow, the investor-analyst must be wary of one-time events that can either hurt or help this metric. For example, a one-time expense can result in a suppressed cash flow forecast.
Company ABC’s CFO would like to understand if she will need to seek external sources of funding to meeting the company’s planned expenditures on fixed assets. She asked her analytical team to calculate the company’s cash flow to fixed assets requirements. The analysts determined the company’s total planned purchase of fixed assets was $7,150,000. They also pulled the latest forecast of net income of $6,150,000, non-cash expenses of $1,250,000 (primarily depreciation) and non-cash sales of $250,000.
Calculating the cash flow to fixed assets requirements ratio:
= ($6,150,000 + $1,250,000 – $250,000) / $7,150,000= $7,400,000 / $7,150,000, or 1.03
Since the ratio is greater than 1.0, the CFO concluded no external funding was needed; however, the team was asked to monitor this metric value very closely over the course of the year.