8 min read
16 Nov 2022
8 min read
16 Nov 2022
Cash flow management is integral to an effective and efficient business operation – playing a key role in fueling growth and building resiliency. Tracking these seven cash flow KPIs and metrics can make it a lot easier.
Healthy cash flow is vital to the overall resilience of a business, determining its ability to pay bills on time, cover unexpected costs, and fund future growth. However, CFOs can face obstacles when it comes to driving cash flow improvements. Ranging from difficulties in forecasting future cash flows to managing the cash flow challenges that come with rapid expansion.
By tracking cash flow KPIs, businesses can gain more visibility over their cash. This can create opportunities to reduce the cash buffer, minimize debt, and/or free up more funds for investment. The right metrics allow CFOs to more accurately track cash flow changes over time, helping them to make more informed decisions about all aspects of operations and take better advantage of their balance sheet.
While there are many different KPIs and cash flow metrics to consider, focusing on a selection such as the following can provide an opportunity to drive meaningful improvements:
Operating cash flow (OCF) is often a prominent item on the cash flow statement. It tracks the cash flows of a business through revenue generation and payment of expenses, but tends to exclude interest and investment returns.
A company with a high operating cash flow may have a greater opportunity to invest in growth. In contrast, a company with a low or negative flow not only has less investment capacity, but may also be jeopardizing its existing operations.
OCF = Net income + Non-cash expenses +/– Changes in net working capital
DSO = Accounts receivable x Number of days in measurement period / Total credit sales.
A company has a net income of $100 million, non-cash expenses of $10 million and a negative change in working capital of $50 million, giving an OCF of $60 million.
Free cash flow (FCF) shows how much money remains after supporting business activities entailed in regular operations and deducting the cost of capital expenditure from operating cash flow. It shows a truer picture of a company’s actual cash flow position, revealing the surplus funds available to reduce debt, distribute dividends or invest in growth.
Free cash flow = Operating cash flow – Capital expenditures
A manufacturing company has an operating cash flow of $60 million and a capital expenditure of $35 million, giving a free cash figure of $25 million.
Working capital is the difference between a company’s current assets and its current liabilities. Dividing current assets by current liabilities gives the working capital ratio (WCR). This provides an indicator of the health of a company’s short-term finances and its general operational efficiency. It’s also a potential guiding light in working capital optimization strategy.
Typical working capital ratios vary depending on the sector. However, as a rule of thumb, a value of less than 1 may be seen as indicative of a business that cannot cover its debts with its current working capital. Although a value of between 1.2 and 2 is generally considered healthy, a ratio beyond 2 could indicate that a business is hoarding cash.
Working capital ratio = Current assets / Current liabilities
A company has $10 million of current assets, while its current liabilities are $8 million. Its working capital ratio is therefore 1.25.
Days sales outstanding (DSO) measures the average number of days a business takes to collect its accounts receivable from its customers.
A short DSO indicates that the business collects its receivables quickly, providing capital to fuel operations and growth. A long DSO suggests a slow receivables collection process that may limit the availability of working capital and harm cash flow efficiency.
DSO = Accounts receivable x Number of days in measurement period / Total credit sales
A company has accounts receivable of $10 million and net credit sales of $40 million. The measurement period is a year (365 days). Therefore, its DSO is 91.25 days.
Days payable outstanding (DPO) is the opposite metric of days sales outstanding and measures the average number of days a company takes to pay its suppliers and creditors.
A low DPO shows that a business is paying invoices quickly, which might indicate sub-optimal working capital management – but it could also indicate that the company is taking advantage of early payment discounts. A higher DPO means the company is taking longer to pay its bills, which is generally seen as favorable as it increases the company’s working capital availability.
DPO = Accounts payable x Number of days in measurement period / Cost of goods sold
A company has accounts payable of $5 million and a cost of sales of $25 million. The measurement period is a year (365 days). Its DPO is therefore 73 days.
The cash conversion cycle (CCC) shows the time a business takes to convert its cash into inventory, and that inventory back into cash. As such, it is an indication of the efficiency of the company’s entire working capital management strategy – factoring in purchasing, inventory management, and sales processes. The shorter a business’s CCC, the less time its cash is tied up in inventory and the more it can be used to fuel growth elsewhere.
CCC is calculated using DSO, DPO and days inventory outstanding (DIO, the average number of days that a company holds inventory before turning it into sales). Performance improvements to any of these three metrics can positively influence the CCC.
Cash conversion cycle = DIO + DSO – DPO
In a one-year period, a company has inventory equaling $4 million and a cost of sales of $25 million, which gives a DIO of 58.4 days. It has a DSO of 91.25 days and DPO of 73 days. The CCC is therefore 76.65 days.
The sustainable growth rate (SGR) is a cash flow metric that shows the rate of growth of an organization using its own revenues, without taking on additional debt. As such, it is a useful metric for determining the company’s future growth strategy.
SGR is calculated by multiplying the company’s retention ratio (the proportion of earnings kept back in the business) by return on equity (the measure of a company’s profitability, comparing net income to shareholder equity). Although a high SGR can indicate that a business is well set up for self-funded growth, this state is generally not sustainable over long periods.
SGR = Retention ratio (RR) x Return on equity (ROE)
Where retention ratio = (Net income – Dividends / Net income) and Return on equity = Net income / Average shareholders’ equity.
A company with an annual net income of $25 million and shareholders’ equity of $100 million distributes $12.5 million as dividends. With a return on equity of 25% ($25 million / $100 million) and a retention ratio of 50% ($25 million – $12.5 million) / $25 million) its sustainable growth rate is 12.5%.
Making use of the right cash flow KPIs and performance metrics for your unique business objectives makes the process of managing cash flow much smoother. Effective tracking of the above KPIs provides insights that help you to better understand how cash moves into and out of your business. This is invaluable when carrying out cash flow forecasting, improving your chances of making the right business decisions to maximize growth without damaging resiliency.
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