Managing Cash Flow and Liquidity
Cash flow is the lifeblood of a company. Too many businesses fail to recognize cash flow problems early enough and run out of liquidity as a result. It’s a common myth that cash flow problems afflict only companies with poor sales. Even a company with rapid growth in sales could find out that it is not generating enough cash flow to sustain the business. Savvy business owners have cash flow and liquidity numbers at their fingertips. What about the rest?
What can you do to make sure that your company does not turn out to be a victim of poorly managed cash flow? You can be proactive in really understanding your cash flow and taking action when you detect problems. Do you need to be an accounting or finance whiz to do this? No! Anybody with a calculator can do some basic analysis that can be sufficient to serve as a barometer for the health of your business. Every business owner need to stay on top of these numbers, even if they have outsourced the accounting function.
Let’s explain a few simple concepts and take a look at some quick calculations that you can use.
How to Use These Ratios
While there are some industry benchmarks that you can use to determine where you fall, what’s applicable to others may not be right for you. If your business has been in operation for some time, you can look at how the ratios compare to ones that your business has seen historically. Whether you calculate and evaluate these ratios on a monthly or quarterly basis is up to you and the frequency at which you update your financial statements. Obviously, more frequently is better. Look at the overall trend, don’t just look at a ratio in isolation.
Do consider seasonality in your business, if there is any, as that could make some ratios diverge significantly from other parts of the year. Not all of these ratios will be applicable to everyone. For example, if you are a services business, the inventory turns ratio will not apply to you.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Current assets include cash and other assets that could be converted into cash within a year. Examples are accounts receivable, inventory, pre-paid expenses, etc.
Current Liabilities include amounts that are due to your creditors (suppliers, banks, etc.) within a year.
What it means: This ratio measures your businesses liquidity, i.e., how much cash can your business raise by selling its assets. Some people calculate the Current Ratio, which does not exclude inventory from the numerator .
How to look at this ratio: A company with a Quick Ratio less than 1 cannot currently pay back its liabilities and could be considered insolvent if all liabilities come due, i.e., creditors demand their money back. The higher the ratio, the more liquid the company is. Quick ratios higher than 2 are generally considered good.
Inventory Turnover = Cost of Goods Sold / Average Inventory
What it means: Inventory turnover tell you how much your inventory turns in a given period, or in other words, how long your goods stay in inventory. Some people use sales rather than the cost of goods sold as the basis of calculation.
How to look at this ratio: The higher the ratio, the better it is for your company. A high ratio implies that your inventory sits on the shelf for a shorter time. The longer inventory stays on your shelf, the more capital is tied up in the business. You also run the risk of declining prices if your goods sit in inventory for too long.
Collection Period or Number of Days Receivable
Collection Period (in days) = Accounts Receivable / Credit Sales per Day
Credit sales per day are calculated as your total sales on credit (remember, these are the only sales generating receivables), divided by the number of days, i.e., 365 for a year.
What it means: This ratio tells you the average time lag between your sales and collection of cash.
How to look at this ratio: You should look at this number in conjunction with the credit terms you give to your customers. For example, if you give your customers 60 days to pay you back, a number less than 60 days would be good. Watch for any creep upwards on this number, especially as you sign on new customers, as it could give you advance warning about the credit quality of your customers.
Payables Period (in days) = Accounts Payable / Credit Purchases per Day
Credit purchases per day are calculated as the total purchases you make on credit (these generate accounts payable), divided by the number of days in the period. For annual purchase data, you would divide this number by 365.
What it means: This ratio tells you the average time between your purchases and payments.
How to look at this ratio: The higher this ratio the better it is, as long as you are not delinquent and you are acting within the terms given to you by your suppliers. A high ratio implies that you are getting good credit terms from your suppliers. Credit given to you is a source of additional liquidity and is always good. Another way of looking at this ratio is to compare it to your collections period. If your collections period is significantly longer than your payables period, it means that you need to invest significant working capital to sell your goods.