The most recent C2FO Working Capital Outlook Survey reports that cash flow problems are the biggest obstacle to business growth for 55% of small and midsize businesses.
The following tools can help you monitor and forecast cash flow so you can maintain a supply of working capital.
Operating Cash Flow Statement
Your cash flow statement includes cash flow related to operations, cash flow related to assets and cash flow related to investments. Of the three, the most important metric for monitoring cash flow is the operating cash flow statement.
Your overall cash flow may be positive, but if that cash flow comes from your investment activities or from taking out business loans rather from than your core business activities, your business may not be sustainable.
The operating cash flow statement focuses on cash involved in operating your business.
You can determine the operating cash flow ratio this way:
Operating Cash Flow Ratio = Cash flows from operations / Current liabilities
Essentially, the operating cash flow ratio shows you whether you are making enough money from operations to pay your bills. A business’s operating cash flow ratio should be 1.0 at a minimum.
The Balance Sheet
Your company’s balance sheet is a financial snapshot of its assets, liabilities and shareholder’s equity at a given moment in time. Organized in sections, the balance sheet lists your:
- Assets (current and long-term)
- Liabilities (short-term and long-term)
- Shareholders’ equity (common stock, retained earnings and current income)
Items should be listed in the order of liquidity. In other words, cash would be listed first in current assets, followed by assets that can quickly be converted to cash.
The balance sheet measures:
Owners’ Equity = Liabilities – Assets
Metrics to Measure
Using data from your financial statements, you should monitor the following metrics regularly:
- Debt-to-equity ratio: Total liabilities divided by total equity. The debt-to-equity ratio helps measure your company’s vulnerability to market changes or economic downturns. Liabilities should never be greater than equity.
- Days Sales Outstanding (DSO): On average, how many days does it take to collect on your receivables? The shorter your DSO is, the better the effect on your cash flow. You can shorten by getting your customers to pay you faster.
- Days of Inventory Outstanding (DIO): On average, how fast does your inventory turn over? The shorter your DIO is, the more positive impact it has on working capital. When inventory is selling rapidly, you aren’t spending money storing and maintaining it.
- Days Payables Outstanding (DPO): On average, how long do you wait to pay your vendors and suppliers? The longer your DPO is, the better it is for your cash flow. Ideally, your DSO should be shorter than your DPO. This means you’ll have enough money on hand to pay your bills.
The Cash Flow Forecast
A cash flow forecast helps you plan for the month, quarter or year ahead and ensure you have enough working capital to meet your needs.
To create a cash flow forecast, you’ll need your sales projections and historical accounting data. Your accounting software should be able to pull historical data and create a cash flow forecast.
Start with at least 12 months of historical data. The more data you have, the more accurate your cash flow forecast will be.
Looking back over your financial statements for one, two or even three years will help you identify how seasonality affects your cash flow.
However, don’t assume the next 12 months will unfold exactly as the last 12 months did. For instance, what happens if the local economy weakens and your customers start paying you in 45 days instead of 30 days?
Once you’ve got a cash flow forecast in hand, compare it to your actual cash flow statement as time goes by. That way, you can get a jump on any trends that affect your working capital needs.
Pay particular attention to your biggest customers, since a small change in their business could have big ramifications for yours.
Making it Easy
Most accounting software today makes it easy to create cash flow forecasts and financial statements, as well as calculate key metrics.
If accounting isn’t your strong suit, have your accountant go over these numbers with you at least once a month.
Monitoring the metrics above will give you an overview of where your business is headed so you can steer it in the right direction.