How do I assess cash flow adequacy for credit purposes?

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AcadiFi · Accepted Answer

Cash flow adequacy is the acid test of credit capacity. Even firms with strong reported earnings can default if cash generation falls short.

CASH FLOW HIERARCHY (most inclusive to most discretionary):

1. EBITDA — earnings before interest, tax, depreciation, amortization
- Non-cash proxy; ignores working capital and capex
- Useful for comparability but not cash reality

2. FFO — Funds from Operations (Moody's preferred)
- CFO before working capital changes
- FFO = Net income + D&A + deferred tax + non-cash items

3. CFO — Cash Flow from Operations (from cash flow statement)
- FFO +/− working capital changes
- Sensitive to receivables, inventory, payables

4. FCF — Free Cash Flow
- CFO − Capex
- Measures cash after sustaining the asset base

5. FCFE — Free Cash Flow to Equity
- FCF − Debt service (interest) + net borrowing
- Cash available for shareholders

CREDIT-RELEVANT ADEQUACY TESTS:

Test 1: Basic coverage
- FFO / Interest > 4x (IG) 
- FFO / Debt > 20% (IG)
- Sources of variation: peer-adjusted

Test 2: Capex coverage
- (EBITDA − Capex) / Interest > 2x
- Reflects actual cash available after asset maintenance
- Critical for cyclical/capital-intensive firms

Test 3: Debt amortization coverage
- (CFO − Capex − Dividends) / Scheduled debt amortization > 1.0x
- Assesses whether firm can self-fund principal repayments

Test 4: Stressed cash flow
- Recalculate FFO at downside scenario (revenue -15%, margin -300 bps)
- Does coverage stay above 2x interest?

Test 5: Liquidity runway
- (Cash + undrawn revolver + projected FCF) vs. (scheduled maturities + contingent calls) over next 12-24 months
- Ratio > 1.2x generally adequate

Worked example — Lumberton Construction Materials:
- EBITDA: $340M
- FFO: $295M
- CFO: $310M (WC release)
- Capex: $180M (growth), $120M (maintenance)
- Interest: $68M
- Scheduled debt amortization: $90M/year
- Dividends: $40M
- Total debt: $1.6B

Metrics:
- FFO/Interest = 4.3x → solid
- FFO/Debt = 18.4% → BB high-end / BBB- low-end
- (EBITDA − maint capex)/Interest = ($340-120)/$68 = 3.2x → solid
- Amortization coverage = ($310-120-40)/$90 = 1.67x → adequate
- Stressed FFO (-15% revenue): ~$220M → FFO/Interest 3.2x, still solid

Verdict: adequate cash flow across multiple tests — credit quality BB+ / BBB-.

EARNINGS QUALITY OVERLAY:
- CFO/Net Income ratio: should be close to or above 1.0x over 3-5 years
- If CFO persistently lags net income, earnings quality is suspect
- Accrual anomalies often precede downgrades

How do I assess cash flow adequacy for credit purposes?

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