Use These 5 Cash Flow Metrics to Improve Your Cash Flow

[Listen to the Podcast version here]

Lack of cash flow is the #1 reason businesses fail.

One of the reasons for this is that many small business owners don’t know how to measure their cash flow. Without measuring cash flow, determining whether changes are having a positive or negative effect on the business can be somewhat subjective. 

Do any of these sound familiar?

• Sales cures all. If I just sell more, my cash flow will immediately get better.
• Let’s cut expenses across the board by 25%. That should close the gap.
• I’ll call the bank and borrow more money. They know I’m good for it.

All of these will give you the feeling of having more cash flow but can have hidden costs associated with them and actually cause more trouble down the road.

There are costs associated with increasing sales.

Depending on your business, those costs may come before you collect a dime – like bringing on additional contract labor to complete a job or buying inventory – if you have to pay the bill before your customer pays you, that’s negative cash flow.

What about cutting expenses?

If cash flow has been tight for a while, you’ve probably already cut back on the low hanging fruit, which means you’ll need to look at cutting expenses on necessary resources – like salaries, keeping less stock on hand, or switching vendors – but if you’re not careful, you can go too far.

Letting too many people go or over-working your people will cause morale and performance issues which your customers will notice eventually. If you drop your stocks too low, you may not be able to meet your customers’ needs on time.

Switching vendors may save you some money but do your research to make sure they provide at least the same quality service as the vendor they are replacing. Cheaper is not always better.

 And using debt to finance operations?

Borrowing money, through a traditional fixed rate loan or a line of credit, can offer a much-needed cash infusion to get you through a tough spot or give you the time you need to push through the growing pains. Where you can get in trouble is not understanding the long-term impacts of repaying the loans.

If you borrow too much, the burden of making the monthly payments can seriously impact your future cash flows.

I want to make one thing clear.

I’m not saying don’t sell more, don’t cut expenses, or don’t borrow money. All of these can be effective ways to improve your cash flow over the long term.

What I am saying is before you do these things, you should have a plan and tools in place to measure whether the changes you are making are helping or hurting your business.

The first thing is to get a base line for where you are now by knowing what your cash flow metrics are. Then you can measure regularly to track how the changes you are making affect your metrics.

Here are 5 cash flow metrics that are typically used to assess financial health of a business:

Working Capital

Working capital is a measure of a business's liquidity and short-term financial health – in other words, does your company have enough cash to meet its short-term obligations like payroll, accounts payable and unpaid taxes?

Working capital helps you ride out cash flow fluctuations since you have cash reserves and can be used to invest in business growth when managed properly. If your business has seasonal fluctuations or you’re still working on building consistent revenue, having positive working capital is key.

Here’s how you measure it:

Working Capital = Current Assets - Current Liabilities

If your current assets are $500,000 and your current liabilities are $350,000, then your working capital is a positive $150,000. If the situation is reversed ($350,000 in current assets and $500,000 in current liabilities) then your working capital is a negative $150,000.

Companies with negative working capital are not able to meet their operational needs – they cannot pay all of their bills on time and may have difficulty raising the funds to bridge the gap.

Measuring the change in your working capital over time can help you make more informed business decisions and see what the short- and long-term impacts of those decisions are.

Operating Cash Flow

Operating cash flow measures the amount of cash that your business generates through its core operations. Positive operating cash flow means that you can maintain and potentially grow your operations.

Negative operating cash flow means that you may need to take on debt to pay your bills in the short-term or if you want to expand.

It can be calculated two ways:

 Direct Method

 Operating Cash Flow = Total Revenue - Operating Expenses Paid In Cash

Indirect Method

Operating Cash Flow = Total Revenue - Cost of Sales + Depreciation - Taxes +/- Change in Working Capital

To measure your operating cash flow ratio, you divide your operating cash flow by your current liabilities.

In the long term, you want an operating cash flow greater than 1.0. As you are making changes to your operations, you’ll see how they affect your ratio.

If you have a seasonal business or your revenues are inconsistent for other reasons, you could see large fluctuations month-to-month, so also look at your ratio on a rolling twelve-month basis to see how you are trending.

Quick Ratio 

The quick ratio measures a company’s ability to pay its short-term debts (those due within the next 12 months) using what’s referred to as near-cash assets.

Near-cash assets or “quick assets” are items that can be converted to cash quickly like marketable securities and accounts receivable.

Other current assets like inventory and prepaid expenses are typically removed from this because it may take some time to convert inventory to cash and vendors may not refund prepaid expenses if you need the cash.

Here's how you calculate it:

Quick Ratio = Quick Assets / Current Liabilities

A ratio less than one indicates the business could have issues paying its short-term debts if it can’t convert its assets to cash quickly enough.

Accounts Receivable (A/R) Turnover

The accounts receivable (A/R) turnover ratio measures how quickly your business collects its accounts receivable. In other words, are you efficient at collecting customer payments or not?

A/R Turnover = Total Credit Sales / Average Accounts Receivable

Note here that total credit sales are used in the calculation, not total sales. You want to measure using only sales that were handled on credit terms to get an accurate calculation.

To calculate average accounts receivable, add the beginning A/R balance and the ending A/R balance for the period you are measuring and then divide by 2.

Low receivables turnover could indicate things like poor quality customers, inadequate credit policies, issues in the order process causing delays in payment and poor collections processes.

Accounts Payable (A/P) Turnover

The accounts payable (A/P) turnover ratio measures how quickly your business pays its vendors.

A/P Turnover = Total Supply Purchases / Average Accounts Payable

What are supply purchases? Think of this as your cost of goods sold for the period.

To calculate average accounts payable, add the beginning A/P balance and the ending A/P balance for the period you are measuring and then divide by 2. 

Over time, a higher ratio indicates faster payments, and a lower ratio indicates slower payments but there may be a wide range of reasons why the numbers change.

Fluctuations in this ratio could indicate active cash flow management – paying vendors on time versus early or a few days late to manage other cash flow commitments is normal.

If you negotiate longer payment terms with your vendors, your ratio will go down over time because you’re keeping your cash longer, but it’s not a negative thing.

However, if your ratio continues to drop and falls too far outside your average payment terms, this could indicate a cash flow problem in the business that needs to be addressed.

How do you get started?

1. Set up a quick spreadsheet with these ratios.
2. Drop your data by month into the spreadsheet. I recommend tracking over a rolling 12-month period to account for random fluctuations in the data so you can see how you are trending over time instead of panicking because one month looks bad.
3. Make notes of any process changes that you made in the period to help evaluate changes over time. (For example, if your A/R turnover ratio is low and you update your collections process, over time, your ratio should increase if the changes you made were effective)
4. Evaluate and adjust over time.

Want help?

Schedule a call and let’s chat!