Cash flow proves critical for small business survival, and a positive cash flow can keep your margins right where you need them to be. Take control of your small business’s finances by managing cash flow with these tips listed below.
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You probably know that cash flow is crucial for a company’s long-term viability. The operating cash flow ratio (CFR) helps assess how a company’s cash flow compares to its obligations, which is a sign of its solvency. Can it pay its current liabilities from the cash flow generated by core business operations? This is a key indicator of the business’ financial health.
To compute the CFR, you need to know two numbers: cash provided by operating activities, or operating cash flow, found on the statement of cash flows, and current liabilities (those due within one year), found on the balance sheet. Divide operating cash flows by current liabilities to get the cash flow ratio..
For example, if your business had $30,000 of operating cash flow and $90,000 of current liabilities as of the end of the fiscal year, your cash flow ratio would be 0.33.
A ratio of less than 1 indicates the company cannot meet its obligations through business operations, and is a warning signal. Conversely, a ratio higher than 1 indicates that the company can meet its current liabilities with cash left over — an indicator that is welcomed by investors and creditors.
Several factors affect the CFR:
To put the cash flow ratio in context, you can do three types of comparisons: period-to-period contrasts, peer-to-peer comparisons, and relationship to other ratios.
Let’s say two companies, SlowCo and ChaosCo, have the same operating cash flow and current liabilities as your business in the example above. For year one, all three companies have a 0.33 CFR. But at the end of the following year, your company’s new CFR is 0.55, SlowCo’s is 1.13, and ChaosCo’s is negative 0.27.
In order for ChaosCo’s CFR to drop to a negative number, their operating cash flow must be insufficient to pay their current liabilities. The company should spend a considerable amount of time investigating the causes, which might include lower profits, increased accounts receivable or inventory balances, or increased liabilities. A period-to-period contrast is a good starting point that indicates there may be a problem, but it’s going to take a bit of work to see how to get the company back on track.
With period-to-period trends, you compare one measure within the same company over multiple periods. Your company’s CFR improved, from 0.33 to 0.55, which, absent other information, does not raise any flags and is a positive sign. SlowCo’s CFR improved by a healthy amount, while ChaosCo’s situation appears to have declined at an alarming rate. You’d want to dig further into what caused these significant changes from one year to the next.
With peer-to-peer comparisons, you compare ratios among similar companies to identify outliers. In the example above, you’d likely want to understand what makes SlowCo’s performance so different from ChaosCo’s. This is a very useful comparison, as studying your competitors is a great way to gain a competitive advantage.
If you’re able to spot what gives your competitors a crucial advantage, you can then explore how you can implement some of their strategies to take your business to the next level. Likewise, competitors at a disadvantage can be useful examples and may present you with new opportunities.
A third technique involves exploring the relationship between multiple ratios. To complement the CFR, you could look into performance or working capital ratios. For example, with SlowCo, you might see that sales decreased from one year to the next, or perhaps the company improved how it managed accounts receivable and inventory. These changes would raise CFR.
With ChaosCo, you might see a significant increase in sales, but one that was coupled with much higher accounts receivable and inventory balances. If you were a creditor or supplier to this company, you’d want to monitor how well it was managing its growth.
To gain a complete understanding of your business’s current financial position, you will first need to check its profitability. A positive monthly cash flow does not necessarily mean your business is profitable. Therefore, it is advantageous to determine your cash inflows and outflows while also taking stock of non-cash items and the products and services you provide to customers.
Gather past financial data and historical accounting information, such as income statements and balance sheets, to consider how you can improve revenue and decrease expenses. Take time to examine your goods or services and their processes to ensure they are optimally performing for you.
One aspect of cash management is deciding how to control the outflow of money. This would be the cash leaving your business through the payment of expenses and other liabilities. To improve cash flow, and decrease outflow, compare the costs of financing large asset purchases and buying them outright.
Instead of tying up your cash in a large purchase of, say, new machinery for your inventory production, consider financing the expense instead. Small, monthly, cash payments are easier to handle than one hefty expense completely depleting your money reserves for the month, or even longer. You can even decide to open a line of credit to help manage those large purchases.
After checking the cash outflow in a business, it is best to turn your attention to the inflow of money and your business’s accounts receivable. Focusing on cash inflows means examining the sales processes and revenue generation of the company to improve output. Try implementing new inventory processes to decrease wastage or update sales techniques to increase revenue.
Your small business’s cash inflow and outflow are directly linked. By decreasing the cash outflow, you could have more money to set aside for further investments or savings to increase the interest made on your accounts.
Find out more about these 11 cash flow items you should be tracking.
The liquidity of a business depends on how much cash they have access to at any given point. It is the money that is free to use and not tied up in other business operations and current assets. Part of cash flow management is knowing what funds you have access to at any given time.
Suppose you need to quickly get your hands on a hefty sum of money that your cash inflow cannot provide you at the time. As the business owner, you will have to decide whether or not to sell off and liquidate some of your assets to cover your monetary needs at that moment.
Suppose your company offers credit to customers or provides longer invoicing payment terms. In that case, your monthly cash flow can significantly fluctuate every 30 days. The business’s payment processing affects cash flow considerably so you will need to stay on top of your business’s accounts receivable. Invoicing immediately increases your likelihood of getting paid fast, and a free invoice generator such as the QuickBooks Invoice Template can automate this process for your business.
As invoice payments are an essential way to bring money into the business, companies must stay on top of unpaid invoices. Keeping track of outstanding receivables and ensuring customers pay what is owed to you is an essential part of cash flow management.
You can schedule your expense payments for business operations, such as monthly rent and utilities, to come out of your account at a specified time of the month. Knowing exactly when a large chunk of money will be leaving your accounts can help you plan your small business’s cash flow accordingly.
If you know when exactly bills must be paid, you can check your working capital and have time enough to liquidate assets or collect invoices before the amount is due.
Knowing when and how much you have to pay for expenses is one thing, but why not expound on that information for a deeper understanding of your cash flow. Small businesses can estimate their future cash flow with projections or cash flow forecasting to determine a plan of action.
Generating a cash flow forecast will provide you with the data and information you need to make smart and successful business decisions. Knowing how to calculate these projections will help prepare you for the future.
How can you manage cash flow if you aren’t acutely aware of where the money is coming from and going to. Analyzing your cash flow involves taking what you have learned from the projections and using it to improve your business’s financial position. Such knowledge can help you determine how to best decrease the outflow and increase the inflow of money.
Cash flow analysis and projections go hand in hand to help business owners obtain a complete picture of the state of their company’s finances and what that means for the future.
Managing cash flow means keeping a pulse on your business’s finances at all times. Millions of companies have turned to accounting software to monitor the inflow and outflow of their finances. Why not do the same for your small business cash flow?
Financial reporting and cash flow projections can make all the difference to your small business, as such knowledge can help you prepare for the imminent highs and lows of money flow. Join the millions of small business owners who have effectively improved their cash flow management thanks to the QuickBooks Online accounting software and try it free today!
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