How to Manage Cash Flow with 4 Simple Metrics

“Cash combined with courage in a time of crisis is priceless.” – Warren Buffett

“Never take your eyes off the cash flow because it’s the lifeblood of business.” – Richard Branson

When we want to do something well, we are wise to look for advice from those who have already accomplished it. It’s pretty safe to say that these two gentlemen have a good grasp on the importance of cash in business.

As CPAs who partner with business owners to help them understand their numbers, we see firsthand every day how valuable cash can be. Those who have it simply have a lot more options than those who don’t.

Without a healthy cash position, your business runs the risk of:

  1. Being stretched too thin when trouble arises
  2. Being at the mercy of those you owe
  3. Being unable to pivot quickly and take advantage of new opportunities

With that in mind, here are a few basic tools we use regularly to help our clients stay cash strong.

4 FINANCIAL METRICS TO KEEP YOU FROM RUNNING OUT OF CASH

CURRENT AND QUICK RATIOS

A company’s Current Ratio is its ability to pay its short-term liabilities with its short-term (a.k.a. “current”) assets. 

Current Ratio = Current Liabilities/Current Assets

Assets considered in a Current Ratio include all items that could be converted to cash within one year, such as: 

  • Cash and cash equivalents
  • Stock Market Investments
  • Accounts receivable
  • Prepaid expenses
  • Inventory 

A company’s Quick Ratio is slightly different. It represents how quickly the company would be  able to pay off its current liabilities since it only includes assets that could be converted into cash within 90 days. Some of the assets listed above that take longer to liquidate (like inventory) are not included, so this ratio is considered more conservative.

Quick Ratio = (Cash+Cash Equivalents+Current Receivables+Short-Term Investments)/Current Liabilities

Both the Current Ratio and the Quick Ratio are useful, depending on the type of business you’re evaluating and what “season” it is in. (You can learn more in this article by Investopedia.)

All businesses go through cycles of ups and downs during the year. If the company is heavily dependent on inventory and has busy/slow seasons (i.e. holidays vs summer), the Current Ratio may not give you as accurate a picture of the cash position as the Quick Ratio. On the flip side, a business that turns inventory over frequently (i.e. a grocery store) might look weak on a Quick Ratio, but strong on a Current Ratio.

It’s important to look at both (along with the following metrics) to get an accurate picture of true liquidity.

DAYS SALES OUTSTANDING OR RECEIVABLE AGING

Day Sales Outstanding (DSO) represents how long it takes a business to collect on its accounts receivable after a purchase has been made.

DSO = Total Credit Sales/Accounts Receivable×Number of Days

The faster you can collect on ARs, the faster you put that cash to work for your business.

For example, a pure cash transaction (I hand you a dollar for a candy bar) would have a DSO of “zero” since there was no time where you were waiting on actual cash after you delivered the product. (For that reason, cash sales are not included in a DSO ratio.)

This is an incredibly valuable metric to be aware of. It lets you know at a glance:

  • How many sales you’ve made in a given time period
  • How quickly you’re getting paid
  • Whether or not your AR processes are functioning smoothly 

(Dig even deeper with this article from the Corporate Financial Institute.)

DEBT-TO-EQUITY RATIO

The Debt-to-Equity Ratio (or D/E) shows how strong or weak a company is in equity.

Debt/Equity = Total Debt/Shareholder’s Equity

If a company has $50,000 in debt and $10,000 in liquid assets, it would have a D/E ratio of 5.

If a company has $10,000 in debt and $50,000 in liquid assets, it would have a D/E ratio of .2.

Therefore, the lower the D/E score, the better. If a company has a high D/E ratio, it shows that it is highly leveraged and represents a greater risk to investors. In the event of any losses, the company may not be able to service its debts. However, a low D/E ratio indicates a strong cash position and an ability to quickly adapt to any losses or unexpected difficulties.

To maintain a strong D/E ratio, keep your debts low and your retained earnings high.

(Harvard Business Review has a helpful article here that explains D/E further.)

OPERATING CASH FLOW RATIO

The Operating Cash Flow Ratio tells you how well your company is able to pay its liabilities within a given period.

Operating cash flow ratio = Current liabilities/Operating cash flow

It is the equivalent of a person’s net income after they have used their take-home pay to cover the rent/mortgage, utilities, phone bill, and buy groceries, etc.

A high ratio (greater than 1) indicates that you are managing your cash flow well and not over-extending your resources. A low ratio (less than 1) shows that your business does not have enough cash on hand to cover your current expenses…too much month left at the end of your money.

(More on this in a brief course from Morningstar available here.)

HOW THESE METRICS BENEFIT YOUR BUSINESS

Much more could be said about each of these 4 metrics, and we actually enjoy getting into the weeds of these kinds of things at CRS CPAs. The key take-away for you, the busy business owner, is this:

The better you know the condition of your cash, the better your business will be.

We understand how frustrating and time-consuming it can be to stay on top of all of these numbers. That’s why we do what we do every day for business owners just like you. We crunch the numbers and keep you updated with accurate, easy-to-understand reports so that you can focus on growing your company and serving your customers.

Give us a call. We’d love to find out how we can help you make sense of your money! 

Nov 18, 2020