In a volatile financial climate where uncertainties continue to loom, cash flow management remains a critical lifeline for businesses of all sizes. It is far more than a simple measure of the money flowing in and out; it is a dynamic interplay of timing, prudent management, and strategic foresight.
If we take to heart the wise words of business magnate Warren Buffett, who insightfully said, "Do not save what is left after spending, but spend what is left after saving," we can gather how a shift in perspective on cash flow can profoundly impact a business's trajectory.
This is especially true in 2024, as the global economy continues to recover and adapt from the impacts of recent years. Businesses across industries have felt the ripple effects, underscoring the essential role of effective cash flow management.
In this article, let's explore the top seven crucial cash flow metrics that businesses should monitor closely in 2024.
To flourish in today's dynamic economy, mastering your business's cash flow using metrics is critical. These metrics serve as financial health indicators, revealing trends and aiding informed forecasting, paving the way for strategic growth.
Days Sales Outstanding (DSO) measures the average number of days it takes for a company to receive payment after making a sale. It is a key indicator of the efficiency of a company's accounts receivable function and the overall collections process.
DSO is calculated using the following formula:
DSO = (Accounts Receivable / Total Credit Sales) x Number of Days
The result gives an average 'days' value, showing how long it typically takes for the company to receive payment. A lower DSO value signifies that it takes fewer days to collect from sales, which is generally better for cash flow.
However, it's worth noting that DSO can vary between industries and businesses. Some businesses may naturally have a higher DSO due to the nature of their operations or their credit terms. Therefore, it's crucial to benchmark your DSO against other companies within your industry for a more accurate perspective.
Consider a hypothetical company, XYZ Corp, that has accounts receivable of $200,000 and net credit sales of $1,000,000, and we're examining a 30-day period. The DSO would be:
DSO = ($200,000 / $1,000,000) x 30 = 6 days
This suggests that, on average, XYZ Corp takes 6 days to collect payment after a sale. If the industry average is significantly higher, XYZ Corp might be operating more efficiently than its competitors in terms of collection.
The quicker a business collects its accounts receivables, the faster it can use that cash for other operational needs. Therefore, by effectively managing DSO, a company can improve its liquidity, reduce the need for borrowing, and create a healthier cash flow.
The Days Payable Outstanding (DPO) metric indicates the average number of days it takes for a company to pay its suppliers and vendors after purchasing goods or services. Like the DSO, it's a vital piece of the cash flow puzzle but from the opposite perspective.
A high DPO implies that a company takes longer to pay its bills, which can be beneficial as it allows the company to use the cash for other operational needs or investment opportunities.
The formula to calculate DPO is as follows:
DPO = (Accounts Payable / Cost of Goods Sold) x Number of Days
To illustrate, let's consider that XYZ Corp has accounts payable of $50,000, a cost of goods sold (COGS) of $500,000, and we're examining a 30-day period. The DPO would be:
DPO = ($50,000 / $500,000) x 30 = 3 days
This means that XYZ Corp, on average, takes 3 days to pay its suppliers after a purchase has been made. If this is significantly lower than the industry average, XYZ Corp may be paying its suppliers quicker than needed, potentially tying up cash that could be used elsewhere in the business.
Monitoring your DPO allows you to align your payment cycles with your collection cycles better, maintaining a healthier cash flow.
This metric can be of help to negotiate better credit terms with suppliers, contribute to improving operational efficiency, and enhance your overall strategic financial planning.
The cash flow forecast metric predicts the inflow and outflow of cash within your business over a certain period. It can help a company anticipate periods of cash surplus or cash deficiency, allowing for strategic planning in terms of investments, debt servicing, or operational expenses.
The calculation of the Cash Flow Forecast entails three crucial elements: initial cash at hand, projected cash inflows (such as sales or receivables), and anticipated cash outflows (like costs, expenses, and vendor payments).
Cash Flow Forecast = Beginning Cash + Cash Inflows - Cash Outflows
For instance, if XYZ Corp starts the month with a cash balance of $50,000, foresees inflows of $100,000 from sales and receivables, and projects outflows of $75,000 for expenses and payments, the Cash Flow Forecast for the month would be:
Cash Flow Forecast = $50,000 + $100,000 - $75,000 = $75,000
This implies that XYZ Corp expects to have $75,000 cash at the end of the month.
Monitoring the Cash Flow Forecast can provide meaningful insights into the business's future financial health, enabling strategic planning and helping prevent cash shortages.
In our blog post titled "How AR Metrics Can Enhance Cash Flow Forecasting," we delve into the importance of integrating key AR metrics into your cash flow forecasting. The post explores various strategies that businesses can employ to achieve more accurate and insightful financial forecasting.
The cash burn rate metric measures the rate at which a company uses its cash reserves or cash equivalents.
This metric is particularly significant for businesses that don't yet have a positive cash flow, as it can help determine how long existing cash reserves will last. A high burn rate, unless paired with strong future revenue projections, could indicate that a company is not sustainable in the long term.
To calculate the Cash Burn Rate, you need to subtract the cash balance at the end of the period from the cash balance at the start of the period.
You would then divide the result by the number of months in the period.
Cash Burn Rate = (Cash Balance Start - Cash Balance End) / Number of Months
For instance, suppose XYZ Corp starts the quarter (3 months) with $60,000 in cash and ends the quarter with $30,000. The Cash Burn Rate would be:
Cash Burn Rate = ($60,000 - $30,000) / 3 = $10,000 per month
This means that XYZ Corp is spending $10,000 of its cash reserves per month. If revenues don't increase, XYZ Corp will need to find ways to decrease its burn rate to maintain financial stability.
The cash burn rate metric can help business stakeholders to make strategic decisions on everything from budget allocation to fundraising needs, making it an essential metric in your cash flow management toolkit.
The Operating Cash Flow Ratio functions as a gauge for evaluating a company's financial resilience and operational proficiency. It determines a company's capacity to address its short-term obligations utilizing the cash generated from its fundamental business operations.
This ratio stands as a pivotal metric in assessing a company's short-term liquidity, providing insights into its capability to meet short-term liabilities with the cash influx from its operational activities.
A higher ratio reflects better short-term financial health, as it shows that a company can more readily cover its current liabilities.
To determine the Operating Cash Flow Ratio, divide the cash flow generated from operations by the current liabilities:
Operating Cash Flow Ratio = Cash Flow from Operations / Current Liabilities
Suppose, for example, that XYZ Corp has cash flow from operations of $100,000 and current liabilities totaling $50,000. The Operating Cash Flow Ratio would be:
Operating Cash Flow Ratio = $100,000 / $50,000 = 2
This implies that XYZ Corp generates enough cash from its operations to cover its current liabilities twice over.
That said, it's crucial to understand that this ratio should not be examined in a vacuum. While a high ratio may signal a company's readiness to meet its immediate liabilities, it doesn't necessarily shed light on its long-term financial stability or profit-making potential.
Operating Cash Flow Ratio provides insights into your business's ability to meet its short-term financial obligations, and it offers an additional layer of understanding to gain a complete picture of the financial situation.
Continuing our journey through the important cash flow metrics, we now come to Free Cash Flow (FCF). FCF is a significant metric that provides insights into the actual liquidity position of a company.
It denotes the cash a company can generate post-accounting for cash outflows necessary to sustain operations and preserve its capital assets.
Unlike other metrics, Free Cash Flow considers capital expenditures (CapEx) - the money a company invests in maintaining or expanding its physical assets, such as buildings and equipment.
Investors hold FCF in high regard as it reflects a company's efficiency in generating cash. Companies with strong FCF can invest in growth, pay dividends to shareholders, reduce debt, and fund other initiatives to enhance shareholder value.
To calculate Free Cash Flow, subtract Capital Expenditures from Operating Cash Flow:
Free Cash Flow (FCF) = Operating Cash Flow - Capital Expenditures
For instance, let's assume XYZ Corp has an Operating Cash Flow of $200,000 and Capital Expenditures of $50,000. The FCF would be:
Free Cash Flow = $200,000 - $50,000 = $150,000
This indicates that XYZ Corp has $150,000 that it could potentially use for strategic investment, paying dividends, reducing debt, or other business activities.
The free cash flow metric can give you a clear perspective on the financial stability and flexibility of the business for future growth and investment.
The Cash Conversion Cycle (CCC) is a comprehensive cash flow metric that illustrates the duration required for a company to turn its investments in inventory and additional resources into cash flows from sales.
Fundamentally, it gauges the length of time each net input dollar remains invested in the production and sales process prior to its transformation into received cash.
The CCC considers three vital components: Days Sales Outstanding (DSO), Days Inventory Outstanding (DIO), and Days Payable Outstanding (DPO).
CCC gives an understanding of the efficiency with which a company manages its working capital and the speed at which it can turn its resources into cash.
The Cash Conversion Cycle (CCC) can be determined using the following formula:
Cash Conversion Cycle = DSO + DIO - DPO
For instance, let's say XYZ Corp has a DSO of 30 days, a DIO of 45 days, and a DPO of 20 days. The CCC would be:
CCC = 30 days (DSO) + 45 days (DIO) - 20 days (DPO) = 55 days
This indicates that it takes 55 days for XYZ Corp to turn its input into cash flows, from the point of outlay for raw materials to the collection of sales revenue.
A shorter CCC is generally preferred, as it means a company's cash is tied up in the sales process for less time, leading to better cash flow.
Conversely, a longer CCC could mean a company's cash is stuck in the sales cycle for extended periods, which may lead to cash flow issues.
On the whole, Cash Conversion Cycle (CCC) is an important tool in managing and predicting cash flow, making it a crucial metric for businesses aiming for financial success.
Successfully managing your cash flow is not a one-time effort but rather an ongoing process that involves consistent monitoring and understanding of key metrics. Here are some best practices for keeping track of your cash flow metrics effectively:
Don’t wait until the end of the quarter or year to review your cash flow metrics. Make it a habit to monitor these metrics regularly, be it weekly, biweekly, or monthly, depending on your business needs and financial cycle.
Use the power of automation to streamline repetitive tasks within the financial team. Constant, for instance, enables the automation of workflows for various applications within your financial tech stack, eliminating manual interventions and reducing potential errors.
With Constant, you can construct new workflows or select and activate from predefined flows, ensuring your business processes are efficient and error-free.
Compare your metrics with industry benchmarks or competitors to understand your financial standing better. This comparison can help identify areas where you are performing well or areas that need improvement.
Always understand the context of your cash flow metrics. For instance, a high DPO might seem beneficial for cash conservation, but if it's significantly higher than industry norms, it could strain your supplier relationships.
Platforms like Constant offer detailed financial dashboards on operations like Accounts Payable and Subscription metrics that provide context and insights into your cash flow metrics.
Unexpected expenses or downturns can happen. Maintaining a cash buffer can help manage such situations without causing significant disruption to your business operations.
Ensure your team understands the importance of cash flow management and how their role impacts it. When everyone in the organization is aware and involved, managing cash flow becomes much more effective.
Effective cash flow management is not simply about monitoring your business's incoming and outgoing cash, but rather it requires understanding the intricate interplay of various metrics.
Regular review of essential cash flow metrics such as
- Days Sales Outstanding (DSO),
- Days Payable Outstanding (DPO),
- Cash Flow Forecast,
- Cash Burn Rate,
- Operating Cash Flow Ratio,
- Free Cash Flow (FCF), and
- Cash Conversion Cycle (CCC)
along with strategic forecasting, can significantly contribute in enhancing your business's financial health and long-term sustainability.
Embracing the power of automation in financial operations, like what Constant offers, can significantly simplify this process. With Constant, you can automate workflows, perform reconciliation, manage contracts effectively, visualize process flows, and access insightful dashboards for a comprehensive financial overview.
Remember, effective cash flow management is key to the financial stability of your business. If you're interested in learning how Constant can help streamline and automate your financial operations, book a demo with us today. Give your business the financial operations advantage it needs to succeed.
