The best way to increase your cash flow is to monitor what is coming in and what is going out within your business. Cash flow metrics are used to evaluate the health of a business, whether you’re looking for investors, need more working capital, or simply want to boost profits. To fully understand this, there are three key essential cash flow metrics to track in your business. In this post, we’re diving into each one of these, how you can calculate them for your business and why they’re so important.
1. Days Sales Outstanding (DSO)
The first essential cash flow metric is called “Days Sales Outstanding”, also known as “collection days”. This collection period refers to the average number of days it takes a business to go from making a sale to receiving the funds.
In other words, collection days are a measure of how long you wait before getting paid, in order to accurately balance cash flow during that time. The formula for calculating a collection period ratio is as follows.
Average accounts receivable / net credit sales x days in the period = total collection days
The days in the period are the number of days in a year or within that specific accounting timeline. To find out the average accounts receivable ratio you simply add up the total accounts receivable at the beginning and end of the same period and divide by 2. And of course, net credit sales are simply the total gross sales minus any returns.
For Example:
$500,000 Accounts Receivable / $3,500,000 Annual Revenue X 365 days = 52.14 Days Sales Outstanding
This means that it takes your business about 52 days to collect payment from it’s customers.
A lower ratio is more favorable, because it means the company can quickly collect outstanding invoices. This can translate into better cash flow for the company to use to support operations. A lower DSO is also a good sign to investors and creditors that the company’s receivables are valid and less likely to be written off as bad debt.
On the flip side, a higher ratio is less favorable. It’s a sign that the company has poor collection procedures or the company works with customer who are unable to pay their invoices.
It’s useful to track your company’s Days Sales Outstanding over a period of time. This allows management the ability to see if there are any changes in the company’s ability to collect customer payments.
2. Inventory Turnover
The second cash flow metric that’s important to monitor is “inventory turnover”. This measures how long your inventory has been sitting on your working capital, while continuing to clog your cash flow. Stated more clearly, inventory turnover measures the time it takes a business to purchase inventory and then collect cash from the sales of those goods.
The exact formula for calculating inventory turnover as it relates to cash flow is explained below.
Inventory Turnover = Cost of Goods Sold / Average Inventory for the Period
Having a high inventory turnover rate is favorable. This means your business sells its inventory quickly, thus increasing your cash flow on a regular basis. However, if you have a low inventory turnover your business will have inventory that sits on the books longer, which means the company’s cash is tied up in inventory. Also the longer inventory sits, the higher the chance that the inventory will become obsolete and unable to be sold.
For example:
$1,500,000 Cost of Goods Sold
($500,000 Beginning Inventory + $800,000 Ending Inventory)/2 = 2.38 Inventory Turnover
This means the company was able to sell its inventory 2.38 times throughout the year.
$1,500,000 Cost of Goods Sold
($3,000000 Beginning Inventory + $2,000,000 Ending Inventory)/2 = 0.6 Inventory Turnover
This means the business was only able to sell 60% of its inventory during the year.
From the two examples above, you can see that having a higher inventory turnover is better for the business.
Inventory turnover is useful when tracked over time to watch the company’s inventory selling trend and to spot troubles. It’s also helpful to compare against industry standards to see how your business compares against its competitors.
The goal is to move inventory quickly in order to decrease the number of days inventory is outstanding. Otherwise, this leads to problems with cash flow and and financial issues may arise as your business needs more working capital.
3. Days Payable Outstanding (DPO)
How long do you wait to pay your vendors and other suppliers? This cash flow metric is the third important number known as “Days Payable Outstanding (DPO)”. This ratio tells you how long it takes your business to pay it’s vendors and creditors. The formula for figuring this out successfully is represented here.
Ending accounts payable / cost of sales/number of days = Days Payable Outstanding
For Example:
$800,000 Accounts Payable / $6,000,000 Annual Cost of Goods Sold X 365 = 48.67 Days
This means, it takes your business about 48.67 days to pay your vendor and creditor bills.
The figures for ending accounts payable can be found on the company’s balance sheet. Cost of sales can be found on your company’s income statement.
A lower Days Payable Outstanding (DPO) is favorable to creditors. Typically this is a sign that:
- The business has sufficient cash to pay vendors on a timely fashion.
- Perhaps the business is taking advantage of early payment discounts offered by vendors.
A higher Days Payable Outstanding (DPO) can be a warning sign to creditors and companies, as this can signal:
- The business has cash flow problems and is having troubles paying their vendors.
- This can be a red flag for liquidity problems for the business.
On average, company typically have a DPO between 30-60 days. However, this can vary by industry. Days Payable Outstanding is a great metric to track over time to watch for liquidity warning signs. It’s also a great metric to compare against your industry standarts to know how your business stacks up against your competitors.
The key to balancing your company’s Days Payable Outstanding is to find the best solution for your small business’ cash flow needs. And don’t forget that you may be able to take advantage of vendor discounts when paying invoices within a certain timeframe. This can help with cash flow and give you more working capital.
The Bottom Line
Without proper cash flow management, a business can’t survive for long. Start by projecting these three major cash flow metrics at least 12 months ahead, then compare the projected results to what actually happens at the end of the year. Continue monitoring these signs of cash flow so you can give your business the best chance at succeeding.
If you need help monitoring your cash flow and working capital, give us a call today. We can help you identify the right metrics from your financial statements and monitor these metrics to ensure a healthy bottom line.