Chapter 9

The Ones You Can’t Take Your Eyes Off: Liquidity and Cash Flow KPIs

In This Chapter

Getting to grips with cash

Understanding the critical nature of cash flow

Appreciating the dangers of liquidity

The most common cause of business failure is not lack of sales or too little profit – it’s running out of money. To ensure this doesn’t happen, you need to incorporate some cash flow and liquidity KPIs into your performance management schedule. Knowing how money is moving in and out of your business (cash flow) and knowing how easy it will be to convert your assets to cash should you need money quickly (liquidity) are essential measures to help you gauge the health, stability and longevity of your business.

Even if you have a brilliant business model and great products that sell well, every business is susceptible to money challenges from time to time. The best way to navigate these periods is to know they are coming before they arrive, and the KPIs detailed in this chapter will help you do just that.

Tracking Your Cash

Running a business day-to-day requires a certain amount of cash to keep things ticking along. Tracking your cash is vitally important in business because you need to know how much money is coming in from sales and any other sources and equally importantly, when that money is coming in. This income then becomes the reserve from which you can pay the bills and cover the overheads of the business. Making sure there is enough money in the reserve to cover those costs at all times is an ongoing challenge for most businesses.

Seasonal businesses, for example, may make all their income across a few months of the year, even though their bills arrive at regular intervals, even when money isn’t coming in. Managing money in this type of environment is especially challenging.

One of the most popular cash flow KPIs is the cash conversion cycle (CCC) which calculates the number of days it takes for an organisation to convert resources into cash. It measures how long each dollar is tied up in the business before being converted into cash via a sale to a customer.

The CCC therefore reveals three important pieces of information:

• The amount of time it takes to sell the inventory or stock (goods the business holds for sale.)
• The amount of time it takes to collect the money after a sale is made (this money is called the receivables).
• The amount of time the company can take to pay its bills without incurring interest charges or other penalties.

Clearly, the longer it takes to convert money spent on creating the product into money in the bank, the greater the risk for the business. It is important to recognise that CCC is not the difference between when the money is spent and when the sale is made but actually the time between when the sale is made and when the money is received from the sale, which could be weeks or even months after the sale. I cover the detailed definition and use of CCC in the section ‘Measuring cash flow in practice’.

Why cash is king

In business there’s a saying: - Cash is king. The reason cash is held in such high regard in business is because it oils the wheels of growth. And cash doesn’t cost anything: If you can manage cash flow properly and ensure that you collect your revenue quickly and efficiently and that revenue covers your costs then you don’t need to borrow money.

Borrowing money costs money (in interest payments) and is a much more expensive way to cover any financial shortfall in a business.

Cash-rich companies have more options and much more flexibility about how they run their business and the decisions they make. They are not rocked or sent to the wall by unexpected expenses, because they have the surplus to cover the costs.

In addition cash in the business means by definition that the income has been received and is banked. In the same way that a bird in the hand is worth two in the bush, cash received today is always better than sales revenue sitting on the balance sheet which still needs to be collected tomorrow.

What cash flow tells you about your business

The cash flow of your business tells you (and your potential investors) three things about your business:

• Operating activity: How you are running the business. Is the business able to generate cash from normal business operation? A strong and efficient business will be able to generate a lot of cash from sales of its products and services, and this will make up the bulk of revenue.
• Investment activity: Cash flow can also tell us where money is being spent in the business. Is the business re-investing in equipment or is it just treading water? Ideally a business should be using its cash wisely to invest in new products, or to upgrade or maintain equipment so as to ensure future growth and profit.
• Financing activity: Cash flow also tells us where money is coming from and where it is going. How much was paid to shareholders? Was there any release of capital?

Measuring cash flow in practice

The cash flow KPIs that are most useful are Cash Conversion Cycle (CCC), Working Capital Ratio, Cash Flow Solvency Ratio, Cash Flow Margin and Cash Flow Return on Assets (ROA).

KPI: Cash Conversion Cycle

Cash conversion cycle (also known as cash cycle ) helps to answer the key performance question ‘How well are we doing at managing a healthy cash flow?’ This metric is usually reported annually, but if cash flow is a concern it should be measured quarterly or even monthly.

Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)

To find the data necessary to calculate CCC you need to analyse sales records, stock or inventory records and accounts. So long as your business keeps complete and accurate account records and has a good handle on inventory, then this KPI should be relatively easy and inexpensive to measure. This metric is really useful for helping to open up discussions around improving efficiency all the way along the supply chain.

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Calculating CCC: An example

To help to make CCC clearer I’ve included an example of how each section of the formula is calculated.

Calculate DIO like this:

• Divide the cost of sales from the income statement by 365 days to calculate a cost of sales per day figure. For example 5,600/365 = 15.34
• Calculate the average inventory figure for the period. For example if you want the average inventory for a year you would go to the balance sheet and add the inventory for the start of the year to the inventory at the end of the year and divide by two to get an average inventory for the period. For example 800 + 870 = 1670/2 = 835
• Divide the average inventory figure by the cost of sales per day figure to give your DIO figure. For example, 835/15.34 = DIO of 54.43

In this example therefore it takes 54 days for the company’s inventory to turn into cash.

Work out DSO like this:

• Divide net sales from the income statement by 365 days to get a net sales per day figure. For example 4,600/365 = 12.60
• Calculate the average accounts receivable figure by looking at the balance sheet and adding how much was sold (although not necessarily paid for yet) at the start of the year to how much was sold at the end of the year and dividing by two to get the average accounts receivable for the year. For example 760 + 680 = 1440 / 2 = 720
• Divide the average accounts receivable figure by the net sales per day figure. For example 720/12.60 = DSO of 57.14

In this example it takes 57 days for the company to collect on sales that go into accounts receivable. In many businesses, sales are not cash sales. Instead an invoice is issued to the buyer to settle the account DSO measures how long it takes for the company to collect that money.

Calculate DPO as follows:

• Divide the cost of sales from the income statement by 365 days to get a cost of sales per day figure. For example 5,600/365 = 15.34
• Calculate the average accounts payable figure by looking at the balance sheet and adding the accounts payable at the start of the year to the accounts payable at the end of the year and dividing by two to get an average accounts payable amount for any given year or period. For example 450 + 540 = 990/2 = 495
• Divide the average accounts payable figure by the cost of sales per day figure to get the DPO figure. For example 495/15.34 = DPO of 32.27

In this example it takes 32 days for this company to pay its suppliers.

Armed with these figures it’s now possible to calculate CCC

CCC = DIO (54.43) + DSO (57.14) – DPO (32.27) = 79.3. Meaning in this example it takes the company 79 days to convert their resources into cash.

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Do not assume that reducing your CCC is always a good thing. Business is about fostering relationships with customers and suppliers. Insisting on immediate payment by customers and delaying payment to suppliers can easily backfire and damage long-term business relationships.

KPI: Working Capital Ratio

The key performance question working capital ratio helps to answer is: To what extent do we hold enough short-term assets to cover our short-term debt?’

Working capital, also known as current position is a measure of current assets minus current liabilities. This metric therefore measures how much you have available in liquid assets to build and maintain your business.

Like so many financial metrics, this one becomes especially useful when it’s converted into a ratio, so that you can compare it to equivalent measurements from other time periods or companies. The working capital ratio indicates whether a company has enough short-term assets to cover its short-term debt. You can extract he data needed to calculate working capital and working capital ratio from the accounting data and balance sheet. It’s wise to measure your working capital once every quarter.

Working Capital Ratio = Current Assets/Current Liabilities

For example, say Company A has current assets of $460,000 ($140,000 in cash, $120,000 in inventory, $80,000 in securities and $120,000 in inventory) and current liabilities of $210,000 ($130,000 in accounts payable, $30,000 in accrued expenses and $50,000 in current debt).

• Working capital = $460,000 – $210,000= $250,000
• Working Capital Ratio = $460,000/$210,000= 2.19

Company A’s working capital ratio of 2.19 means that for every dollar in liabilities it has $2.19 in assets.

In general, companies with strong, positive working capital are more successful, since they have the financial resources to expand and improve their operations. Companies with negative working capital will probably lack the funds for growth or be forced to borrow money for expansion, and this can put additional pressure on the cash position.

Working capital ratio is often closely followed by investors because it is a measure of an organisation’s overall health and liquidity. A negative working capital position makes your business unattractive to potential investors and can negatively impact your share price.

Working capital ratios vary by industry, although a ratio of between 1.2 and 2.0 is widely considered sufficient.

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Explanation of Important Data Locations

The key locations for the data you need to carry out the calculations in this chapter area as follows:

• The Balance Sheet: This financial document summarises what your company currently owns (assets), what it owes (liabilities) and what it is worth to its shareholders (shareholder equity).
• The Income Statement: This financial document lists all your company’s revenues over a certain period such as a quarter or year. It is this document that details what profit was made.
• The Statement of Cash Flow: This financial document lists your company’s cash position including inflows and outflows of cash. This document is focused on whether the company generated cash.

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KPI: Cash flow solvency ratio

The key performance question cash flow solvency ratio helps to answer is: ‘How easily are we going to meet our debts?’ The data you will need to calculate the cash flow solvency ratio can be found from your balance sheet and statement of cash flows.

Cash flow solvency ratio = Cash Flow from Operations/Total Liabilities

If you were to decide to seek funding, this metric would be of particular interest to decision makers at the funding organisation because it indicates how easily you can pay your current debts.

The higher the ratio, the better as it indicates that there is plenty of money in the pot to pay the debts. A lower cash flow solvency ratio means you have less financial flexibility and are more likely to run into problems.

Looking Out for Liquidity

Although closely connected to cash flow, liquidity is slightly different. Whereas cash flow is the actual movement or flow of cash around the business, liquidity is a measure of where that money is located and how quickly it can be accessed. When a business is liquid it either has a lot of cash in the bank or it can liquidate short-term investments or assets quickly to convert those assets to cash when needed.

A business may own a huge warehouse worth millions of dollars, but that asset is not a liquid asset as it may take many months or years to sell. A portfolio of shares would be much easier to liquidate and gives the company much more flexibility and room to move and grow.

The often unseen danger

Often when businesses are focused on profit and growth they will want to use all their resources and assets to push growth forward. The danger in that strategy however is the unforeseen. Even the smartest leaders and executives will get it wrong some of the time. Markets and economies change – often rapidly – and if you don’t have enough money in the bank or assets you can convert into cash you can easily land in hot water.

You need to strike a balance between maximising your reserves and making your money work for you, and maintain a safety net – or at least quick access to a safety net – should the need arise.

Measuring liquidity in practice

The liquidity KPIs that are most useful are Current Ratio, Quick Ratio, Cash Ratio and Days of Working Capital. These metrics help you to measure how well your business can use its short-term assets to meet its short-term liabilities. Liquidity KPIs help determine business health and offer insight into your exposure to risk and therefore give you the opportunity to reduce that risk if necessary.

KPI: Current Ratio

The key performance question that current ratio helps to answer is: ‘Do we have the money to meet our short term obligations?’ This metric measures the amount of current assets you have to pay for every $1 of current liabilities. The data you will need to calculate this KPI is located on the balance sheet.

Current Ratio = Current Assets/Current Liabilities

Current assets include cash, inventory and accounts receivable. Current liabilities include accounts payable, current debt and tax liabilities.

Your company is in good health if your current ratio is 2 or more. This means that you assets are twice as high as your liabilities and you have more than enough assets to pay what you owe.

A ratio of 1 or less indicates concern, because your assets are worth either the same or less than your liabilities. This means that you may not be able to pay all your debts. Although not a great sign, it doesn’t automatically spell disaster, but you will need to access more funds or improve efficiency to increase assets.

The current ratio will give you a sense of how efficiently your business is run and how easy or otherwise it is to turn your goods and services into cash. Companies that take too long to be paid or have a long lead time for their product can easily run into liquidity problems because they can’t get the money in fast enough to pay their debts.

That said, what is perceived as a good or bad current ratio does vary between industries. In order to get a better sense of how acceptable your current ratio really is then compare it to other companies in your sector.

KPI: Quick Ratio

The key performance question that the quick ratio, also known as the acid test ratio helps to answer is: ‘To what extent are we able to meet our short-term obligations with our most liquid assets?’ This metric is a more conservative look at liquidity than current ratio, because it only takes cash and account receivables into account, not inventory.

Quick Ratio = (Current Assets – Inventory)/Current Liabilities

By excluding inventory from current assets you get a much more realistic picture of how quickly you can meet your business liabilities, especially if it wouldn’t be easy or even possible to convert the inventory into cash quickly. If, for example, you sell aircraft, they may be worth a great deal but the market is very small and the sales process may take months if not years.

If you have a quick ratio of 1 or more the business is healthy and able to meet its liabilities from existing sales already made, plus cash. A lower quick ratio indicates that your business may not be able to pay for its current debts. This metric can alert you to potential challenges ahead so you do something about it - whether that is ramp up your sales effort, have a fire sale to raise funds or sell off or rent some premises.

KPI: Cash Ratio

The key performance question that the cash ratio helps to answer is: ‘To what extend can we meet our debts from the cash in the business?’ This metric is the most conservative liquidity KPI because it only considers cash as an asset.

Cash Ratio = Current Cash/Current Liabilities

Inventory and account receivable are not included in this measure because they are not definite enough. Inventory needs to be sold and the customer needs to pay. It may be harder to make this happen than it looks: Although accounts receivable details orders that have been made, the customers have not yet paid for the orders so it’s not absolutely certain that you will receive that cash.

As a result the cash ratio is always lower than the quick or current ratio. It is an assessment of the immediate position, and your ability to meet current liabilities without cashing payment or selling more inventory.

KPI: Days of Working Capital

The key performance question that the days of working capital helps to answer is: ‘How long will we survive after paying all current liabilities?’ This metric refers to the amount of current assets you would have after paying all your current liabilities.

Days of Working Capital = Working Capital/Sales Revenue per Day

You calculate working capital by deducting current liabilities from your current assets. And you work out sales revenue per day by dividing your total sales by 365 days.

So, for example, if your current assets were $230 million and your current liabilities were $190 million, your working capital would be $40 million. If your total sales were $130 million your sales revenue per day would be $356,164 which means that you have 112 days (40,000,000/356,164 = 112) of working capital.

A healthy business has 30 days or more working capital.