Gaining a solid grasp of cash flow is fundamental to ensuring the long-term sustainability of your business finances. Cash flow represents the inflow and outflow of money within your company over a specified period. When the money coming in exceeds the money going out, you enjoy a positive cash flow, signifying a robust financial state. However, delving into the intricacies of cash flow calculations and comprehending cash flow metrics and key performance indicators (KPIs) can be instrumental in guaranteeing you have sufficient funds to cover expenses and facilitate business growth.
What Are Cash Flow Metrics?
A metric refers to any measurable gauge of a business function. When it comes to cash flow metrics, they serve as financial indicators that reveal the efficiency of a company’s performance. These measures not only aid in making informed decisions but also assist in evaluating the effectiveness of economic strategies. Additionally, investors utilize this valuable information to make comparisons between different companies.
Key Takeaways
Measure cash flow with KPIs and metrics, and use them to benchmark against historic data and other similar businesses.
Cash flow management KPIs can help you understand current and potential financial position so you can make better informed business decisions.
Targeted KPIs and metrics enable your business to respond rapidly in times of financial crisis.
Cash Flow Metrics vs. Cash Flow KPIs
Cash flow metrics can be easily found on financial statements, offering simple measures of information. On the contrary, Key Performance Indicators (KPIs) delve deeper, providing valuable insights and giving significance to the metrics. For instance, while observing the net income metric is useful, its true meaning emerges when accompanied by additional information, such as performance trends over time or the relationship between assets and liabilities. KPIs related to cash flow are essential financial metrics that serve as guiding principles for management and stakeholders when making critical decisions.
Is cash flow a KPI?
Cash flow statements are summary documents that detail the cash or cash equivalents going into and leaving your business. There are many cash flow related KPIs, including operational cash flow and working capital measures.
Cash flow vs. profits
Cash flow is different from profits. Cash flow measures money coming into and going out of the business. Profit is the money left over after the business pays its bills.
How Do You Measure Cash Flow?
The cash flow statement provides a comprehensive overview of the cash inflows and outflows for your company during a specific timeframe. On the other hand, the balance sheet offers valuable insights into your company’s overall health, including details about its liquidity, fluctuations in assets and liabilities, and shareholder equity. Publicly traded companies are required to file three financial documents with the SEC, which includes the cash flow statement, the income statement, and the balance sheet, each contributing to a comprehensive understanding of the company’s financial standing.
How to measure cash flow performance
Cash flow statements include three components. This information provides you, as well as potential investors, with insight into your company’s financial health.
Operating activities, including transactions from buying and selling inventory, supplies and paying salaries and wages.
Investing activities, such as treasury notes or other securities, as well as gains or losses from the sale of equipment.
Financing activities, which include interest fees paid or received, payment of long-term debt, issuing debt or stock, and payment of dividends.
Top 10 Cash Flow Metrics and KPIs
Effective cash flow metrics and KPIs offer valuable insights into your company’s financial health and future prospects. Investors can calculate some of these metrics by analyzing figures from financial statements.
These metrics serve as crucial indicators for investors, providing a deeper understanding of a company’s financial situation. For business owners and stakeholders, KPIs play a pivotal role in making important decisions. They can help inform choices related to exploring new product lines or optimizing internal processes, such as revamping accounts receivable procedures. By utilizing these metrics and KPIs, businesses can make well-informed decisions that lead to sustainable growth and success.
1. Operating cash flow
Operating cash flow (OCF) represents the flow of funds in and out of a business. Typically, it occupies the top position on the cash flow statement and may also be referred to as “cash flow from operating activities” or “net cash generated from operations.” Notably, this metric does not encompass revenue derived from interest or investments.
An exceptional operating cash flow is sufficient to sustain a business operations independently, without the need for additional loans or external investments. It serves as a strong indicator of a company’s financial strength and its ability to fund its day-to-day activities without relying on external sources of capital.
o determine the operating cash flow KPI using the income statement, sum up the net income and the non-cash expenses, and then subtract any working capital increases.
For example, a large telecommunications company reported the following data on its cash flow statement (in millions):
Net income: $7,500
Depreciation and amortization: $20,000
Inventory adjustments: -$13,000
Accounts receivable adjustments: +$2,200
Accounts payable adjustments: -$1,400
This company’s OCF = $7,500 – $2,200 + $13,000 -$1,400 + $20,00 = $36,900.
This result is a good year with plenty of operating cash flow for this company.
2. Working capital
Working capital is a vital indicator of a business liquidity, illustrating its ability to generate cash efficiently. This metric takes into account short-term investments that can be readily converted to cash within a year, as well as cash on hand and accounts receivable. Simultaneously, it considers liabilities, including accounts payable.
To calculate this metric, simply subtract the total liabilities from the total assets, as listed on your balance sheet. The resulting value represents the working capital. To express it as a ratio, divide the working capital by the total assets or total liabilities, depending on your preference. This ratio will provide valuable insights into your company’s financial health and its capacity to meet short-term obligations.
A working capital ratio greater than 1 means that your company can pay its current liabilities.
For example, a company’s balance sheet has $400,000 in current assets, considering its cash, accounts receivable and inventory. It has $215,000 in liabilities, considering its accounts payable, short-term debt, recent notes payable, payroll and accrued expenses.
This company’s working capital ratio = $400,000 / $215,000 = 1.9. This result shows this company has almost $2 in assets for every $1 in liabilities.
3. Forecast variance
Forecasting future financial positions is a standard and beneficial practice for companies. The forecast variance, also referred to as the variance formula, quantifies the disparity between the predicted values and the actual outcomes. Continuously tracking this variance over time enables businesses to comprehend and enhance their forecast accuracy. The variance can be expressed as an integer (absolute difference) or a percentage (relative difference) to better evaluate the extent of the forecass deviation from the actual results.
This company’s forecast variance = [($12,500-$10,000) / $10,000] x 100 = 25%. A significant event may have helped improve the business in January. This can inform future forecasts.
4. Days Sales Outstanding
Days Sales Outstanding (DSO), sometimes referred to as debtor days, represents the average number of days it takes for a company to collect payment for its sales.
A low Days Sales Outstanding (DSO) signifies that buyers promptly pay your company for its goods or services. On the other hand, a high DSO may indicate collection issues that can potentially affect your cash flow.
For instance, consider an office furniture retailer with $40,000 in accounts receivable for the quarter and $240,000 in sales during the same period. Given that the quarter consists of 90 days, the DSO can be calculated as follows:
DSO = (Accounts Receivable / Total Sales) * Number of Days
DSO = ($40,000 / $240,000) * 90
DSO = 0.1667 * 90
DSO = 15
In this example, the DSO for the office furniture retailer is 15 days. This means, on average, it takes the company 15 days to collect payments from its customers after making a sale. A lower DSO in this context is beneficial as it indicates efficient and prompt collections.
This retailer’s DSO for this quarter = ($40,000/$240,000) x 90 days = 15 days. The standard for what’s a reasonable DSO varies by industry. In retail, that might be around seven days, where in manufacturing it might be closer to 60. Monitor trends over time and compare your performance against peer companies.
5. Days Payable Outstanding (DPO)
Days Payable Outstanding (DPO), commonly referred to as creditor days, represents the average time taken by a company to settle its invoices or accounts payable.
A higher number of Days Payable Outstanding (DPO) could signify that a company has more cash available for short-term investments. However, excessively high DPO may indicate a risk of losing creditors or favorable credit terms. On the other hand, if the DPO is too low, it suggests that the company is not utilizing its credit period effectively.
For example, consider a company with average accounts payable of $400,000 per year and Cost of Goods Sold (COGS) of $5,500,000 for the same year. The number of days in that period is 365. To calculate the DPO:
DPO = (Accounts Payable / COGS) * Number of Days DPO = ($400,000 / $5,500,000) * 365 DPO = 0.0727 * 365 DPO = 26.5
In this instance, the DPO for the company is 26.5 days. This means, on average, it takes the company 26.5 days to pay its accounts payable. A company must strike the right balance in its DPO to ensure it optimizes its cash flow and maintains healthy relationships with creditors.
This company’s DPO = ($400,000/$5,500,000) x 365 = 27 days. Therefore, this company takes an average of 27 days to pay its accounts payable. Around 30 days for creditor days is usually considered an excellent DPO.
6. Accounts receivable turnover
The accounts receivable turnover ratio, also referred to as the debtor turnover ratio, provides valuable insights into the effectiveness of your company’s debt collection process.
A high accounts receivable turnover ratio indicates that a company is adept at collecting payments from its customers. The more frequently a business can turn over its accounts receivable, the more efficiently it can collect money owed to it. Conversely, a low accounts receivable turnover ratio may suggest that a business faces challenges in collecting from customers or is offering overly lenient payment terms.
For instance, consider a company with a beginning accounts receivable of $50,000 and an ending accounts receivable of $54,000 for the year. The average accounts receivable for the year is calculated as ($50,000 + $54,000) / 2 = $52,000. The net credit sales for the year amount to $600,000.
The accounts receivable turnover ratio for this company is determined as $600,000 / $52,000 = 11.54. This indicates that the company turned its receivables into cash approximately 11.54 times during the period. Whether this ratio is appropriate for the company depends on its specific payment policy and business context. A higher ratio is generally preferred, as it implies faster collection of payments and better financial health. However, the adequacy of the ratio should be assessed in light of the company’s unique circumstances and strategic goals.
7. Accounts payable turnover
The accounts payable turnover ratio, also referred to as the creditos turnover ratio, quantifies the frequency with which a company settles its outstanding dues to creditors within a specific period. This metric serves as a key indicator of the company’s short-term liquidity.
As an example, les consider a company with a beginning accounts payable of $5,000 and ending accounts payable of $15,500 during a year. Throughout that period, the company made credit purchases of $20,000 for new equipment.
To calculate the accounts payable turnover for this company:
Accounts Payable Turnover = Credit Purchases / Average Accounts Payable
Accounts Payable Turnover = $20,000 / [($5,000 + $15,500) / 2]
Accounts Payable Turnover = $20,000 / $10,250
Accounts Payable Turnover = 1.95
This result indicates that the company pays its average accounts payable balance approximately 1.95 times every year. To interpret this value effectively, is essential to compare it with similar companies in the industry and consider the vendor payment terms. A higher turnover may imply faster payment to creditors, positively impacting the company’s relationship with vendors and its short-term liquidity.
8. Current ratio
The current ratio assesses a company’s capacity to settle its short-term liabilities. It is important to differentiate between liquidity and cash flow as they are not synonymous. A company may have negative cash flow yet remain highly liquid if it possesses a substantial cash reserve.
Ensure that current assets include accounts receivable, and current liabilities encompass accounts payable and accrued expenses. A higher current ratio indicates that your business is better positioned to fulfill its short-term debts. Generally, a current ratio between 1.5 and 2.5 is considered indicative of good liquidity. For instance, a current ratio of 1.5 implies that your company has $1.50 in current assets for every $1 in current liabilities. Monitoring this ratio is crucial, as low ratios might signify challenges in covering upcoming bills.
For example, les consider a large company with current assets valued at $45,000 and current liabilities at $39,000 (in millions).
The current ratio for this company is calculated as $45,000 / $39,000 = 1.15. This value indicates that the company is meeting its financial obligations, but there is room for improvement to enhance liquidity further.
9. Return on equity
Return on Equity (ROE) is a return on investment metric that measures a company’s net income in relation to its shareholder equity.
Ideally, this percentage should show an upward trend over time, reflecting how effectively a company utilizes its investor capital and the returns it generates from the funds raised. A decreasing ROE over time could signify questionable investment decisions.
For instance, consider a large company with earnings of $40,000 and shareholder equity of $390,000 (in millions) for that year.
The ROE for this company is calculated as follows: ROE = ($40,000 / $390,000) x 100 = 10.26%. By tracking the ROE over time and comparing it to previous years, one can identify trends and gain insights into the potential financial future of the company. A rising ROE suggests improved profitability and efficient use of shareholder equity, whereas a declining ROE warrants further analysis to understand the underlying causes and address potential concerns.
10. Cash flow from operations
Cash flow from operations, also known as operating cash flow, refers to the sum of cash a company generates from its regular business activities, including the sale of goods or provision of services, within a specified period, commonly a quarter or fiscal year.
For instance, consider a company with an operating income of $8,500 (in millions), depreciation of $0, and changes in working capital of -$1,200.
This company’s cash flow from operations can be calculated as: $8,500 + $0 – $1,200 = $7,300. Therefore, this business generated $7,300 in cash flow for that year.
However, there are limitations to operating cash flow. It does not include costs related to purchasing and maintaining fixed assets, nor does it consider the impact of changes in working capital. Consequently, operating cash flow may not always provide a clear picture of a business financial struggles. For a more comprehensive assessment of a company’s ability to grow and meet its financial obligations to investors and creditors, free cash flow considers these factors and more, offering a more complete view.
How to Pick the Right Cash Flow KPIs for Your Organization
The KPIs you decide to monitor will differ based on your industry, business, and even specific roles within your company. For instance, executives might prioritize medium and long-range goals, while line managers may concentrate on short-term metrics of success. However, some general guidelines can aid you in selecting your goals.
First, aim to be specific about what you want to achieve. Clearly defined objectives provide clarity and direction for your efforts. Next, ensure that your goals are realistic and achievable, considering your company’s resources and capabilities. Not all KPIs will be relevant to every individual in the business, so tailor them to suit different teams and functions.
Setting appropriate business goals that align with your company’s overall strategy is a fundamental practice that significantly influences growth and financial well-being. By monitoring and striving towards these objectives, your organization can chart a path towards success and continued improvement.
When selecting measures to assess your business performance, is essential to consider both qualitative and quantitative aspects. Quantitative data, readily available from your financial statements, provides numerical insights. However, to gain a more comprehensive understanding of the underlying factors, incorporate qualitative measures that describe the context and narratives behind the numbers.
Qualitative information offers valuable context and can include aspects such as customer satisfaction levels, incidents that may have affected your business reputation adversely, or instances of high employee turnover. These qualitative factors provide a deeper perspective on the numerical data, shedding light on the reasons and implications behind the figures.
By combining both quantitative and qualitative measures, you can gain a holistic view of your business performance and make informed decisions that address both numerical outcomes and the broader factors influencing them. This balanced approach to data analysis enables you to effectively assess and improve various aspects of your business, ultimately contributing to its success and growth.
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