It is well accepted that cash flow keeps a business healthy. Apart from this, however, there are other conventional parameters that help to assess the well being of your business.
Of these, one of the critical measures is profitability. This means evaluating how effectively your assets and funds are used. When short term financial needs arise, you also need to be alert about liquidity. Thus, the conventional parameters, namely profitability, efficiency, leverage and liquidity will affect cash flow. Let us take a brief look at each of these:
Profitability relates to three specific factors, namely gross margin, operating expense ratio and cash flow. Gross margin and operating expenses as a percentage of sales are both major cash drivers. Any cash that is left over from the sales dollar after deducting the cost of goods sold and expenses is the “cushion” money.
This cushion takes care of payments to your banker, your government and your shareholders. In case there is not enough margin, this cushion money might be controllable by managing expenses in a better manner. In the case where expenses are way beyond the expected level, you must turn to gross margin to manage the difference through reworking pricing or handling purchases and production more effectively.
Long term profitability is dependent on dividend-payout ratio and capital-expenditure ratio. Dividend payout comes down as the company invests in growth. Cap-ex ratio goes up in new opportunity development.
How effectively assets and funds are used can be measured through inventory and accounts receivables management which are measured in terms of days. This means, you have to answer these questions:
- The number of days worth of sales in accounts receivable
- The number of days worth of cost of goods sold in inventory
Obviously these two are inter-connected. When sales rise, investment in inventory and accounts receivable also rises proportionately, maintaining the duration. This makes more sense than comparing absolute dollar values that are affected by other variables like growth, seasonality, etc. Mainly, the aim remains to minimize inventory and receivables and maximize accounts payable in order to optimize cash flow.
Another measure of efficiency is the return on cash assets. There must be enough to be able to pay off bills as and when due. Any extra cash must be invested back in operations and developing the business in order to see high returns.
Asset efficiency is also measured by sales, where the focus is on investment of assets needed to generate one dollar of sales. Thus, the aim is to get more sales per dollar of assets utilized, thereby maximizing return on investment made.
A business need not be the owner of an asset to be able to utilize it. One can lease an asset without adding it to the balance sheet. But then you might actually be pay more for something that is not owned by your business and therefore, the decision to own or lease must be made after careful consideration. Some businesses solve the problem by outsourcing or contracting the entire activity undertaken by the asset.
While assessing your business’s well being, leverage relates to the efficiency with which you take advantage of your net worth or equity to get the best return from investment. Too much leverage however, can come at a price. Too much leverage could mean that your creditors and business must face a risk, since too many liabilities could corner you in case things do not go as expected.
It could mean employee turnover, banks calling in their loans and suppliers not sending your material in time. Here is where the cash flow link is – the greater the leverage, the higher the risk of other peoples decisions stopping the cash flow. The lower the leverage, the lower the return on investment. To strike a balance, is the key.
This factor is the closest to cash flow among the four factors that are used to assess your business’s well being. Liquidity is calculated by the short term assets to short term liability ratio. If the assets, that is accounts receivable and inventory are more than the liabilities by a broad margin, cash flow is more likely to be healthy.
An asset is liquidated and cash flows in only once the inventory is converted to sales, receivables and then cash. This cash is then used to clear supplier bills, worker wages and other payments when they are due. This ratio, however is rather limited in approach as it does not touch upon operational cash flow.
Insolvency Is The Ultimate Cash Flow Risk
If the business’s cash outflow is far too much without adequate cash inflow, the company may be insolvent. Some businesses shut operations that are not profitable, layoff employees, dispose off assets that are not essential and rework their debts. In many cases, creditors receive less than what they are owed.
Liquidations, receiverships and administrations can be avoided by managing the seven cash drivers carefully. While sales growth is the biggest cash flow driver, gross margin and operating expenses are basic drivers since they look at the firm’s production, purchases, marketing and general management.
Accounts receivable, inventory and accounts payable are called “swing drivers” because no matter what the situation, these can actually turn around a business’s cash flow situation from negative to positive when managed properly. Capital expenditures are critical costs and matching how you pay for them with the way they produce results is critical.