5 Simple tools to analyse your business cash flow
This article is a continuation of the previous two articles Cash Flow Problem - treat the cause not the symptom and 8 Ways Poor Cash Flow Is Affecting Your Business. I would highly recommend you read these two hubs before reading this one to understand my perspective on cash flow and small business.
In a perfect world you would have access to all information to make the right decision for your business. However, in reality a small business does not have the resources to gather all the information that may be necessary to make a complete analysis of your cash flow. Below are 5 simple tools that you can use to help analyse your business and its cash flow.
1. Observation and common sense – ‘Strategy requires thought; tactics requires observation’ is one of my favourite quotes by Dutch chess grandmaster Max Euwe. His quote about chess is just as appropriate to business. Strategy is what is to be done and tactics is how to achieve it. It will not matter if you have the best strategy in the world if you can’t implement it. Taking the time to observe what is happening in your business is critical to analysing your processes which may affect cash flow. The busyness of managing a small business can sometimes cause you to overlook the simplest solutions. Take time to observe the different processes in your business with no agenda or preconceived ideas. Sometimes this meant just sitting and watching a certain activity and other times sitting down and drawing a simple flow chart of the process. It is during these times I have had some of the simplest and best ideas.
2. Industry Reports – In this information age there is a wealth of information available to assist you in understanding how your industry is performing with regard to external factors, competitors, trends and growth. Industry reports may be purchased from industry research companies though the cost of these reports can be prohibitive for a small business. However, spending a little time on google can uncover enough industry information to analyse your industry and business. Generally I start by googling the industry name with the words 'industry report'.In Australia you may be able to obtain at small charge an industry report from the business development department of the State government. I have been able to obtain free reports sometimes by visiting the office.
3. Cash Cycle Analysis - The cheapest and best source of cash for a business is the efficient management of the cash cycle. The cash cycle is the length of time it takes from purchasing your stock till you receive payment from your customer. We can measure this cycle with the following performance indicators:
· Days Inventory – the average number of days your stock is held before being sold.
· Days Receivable – the average number of days to collect cash from your customers.
· Days Payable – the average number of days to pay your suppliers.
The Cash Cycle = Days Inventory + Days Receivable – Days Payable
Generally, the shorter the number of days the better the cash flow. However, it is not recommended that you hold off paying suppliers to reduce your cash cycle. The cash cycle can also be compared to industry norms as well as being reviewed for efficiency.
You can download a spreadsheet on my website to assist you to calculate the cash cycle.
4. Liquidity Ratios - Liquidity ratios measure the capacity of the business to meet short term financial commitments as they become due. The two commonly used ratios are the current ratio and the quick ratio.
The current ratio is a measure of whether your business can meet its short term financial obligations as they become due. The higher the ratio, the better the business is able to meet its short term financial commitments. A current ratio of 2:1 is regarded as desirable for a healthy business. However, every industry or business is different. As a general rule, try to achieve a current ratio above 1:1 and as close to 2:1 as possible.
The quick ratio measures the current assets that can be quickly converted into cash to meet short term financial obligations. The quick ratio provides a more conservative measure than the current ratio because it excludes inventory. The optimal quick ratio is regarded as 1:1 or higher, which means that current liabilities can be met from current assets without the need to sell inventory.
How to calculate the ratios:
Current Ratio = Current Assets/Current Liabilities
Quick ratio = (Cash + Marketable Securities + Accounts Receivable)/ Current Liabilites
5. Growth Analysis - Growth analysis shows how the business has managed its operations compared to revenue growth. The revenue growth from the previous period is compared to the growth in expenses, cost of goods sold and accounts receivable. The cost of goods sold growth is also compared to the growth in accounts payable and inventory. For example, if revenue has grown 5% over the past year and accounts receivable has grown by 12% then this will have a negative effect on the cash flow and should be examined.
If cash flow is an issue for your business, then you can download my free ebook "10 Cash Flow Strategies for a Successful Business" here.