Analyze Your Cash Flow Trends

One of the best ways to track a business’s health is by analyzing cash flow trends. Performing ratio analyses each month will give you a concrete way to measure how well your business is managing your cash.

To begin you’ll need a year’s worth of company financial data. Then you can create three key ratios from figures on your income statement. These ratios will tell you how long it takes you to collect payments from customers, how long you take to pay vendors, and how long your inventory takes to sell.

First, determine your accounts receivable turnover rate — an average of how long it takes your customers to pay their bills. Start by adding up your daily receivables for the whole year, then add up the total sales you made on credit in the past year. Next, divide the receivables total by 365 to get your average daily receivables. Then multiply average receivables by 365, and divide the sum by total credit sales. The result is the number of days it takes you to collect your average bill.

Say average daily receivables at Joe’s Garage are $30,000 and it sells $250,000 a year on credit. Joe’s typically takes nearly 44 days to collect from customers who buy on credit.

To find out how quickly you pay vendors, calculate your accounts payable turnover. Add up daily outstanding credit purchases for a year and divide by 365 to get average daily payables. Then add up total purchases made on credit for the year. Multiply average daily payables by 365, then divide by total annual credit purchases. The result is the number of days it takes your business to pay a typical bill.

Joe’s average daily payables are $15,000 and it buys $240,000 on credit a year. Joe’s is paying suppliers in an average of 23 days — three weeks before customers pay Joe’s.

To complete the business picture, calculate your inventory turns ratio. Add daily inventory figures for a year and divide by 365 to get average daily inventory. Multiply average daily inventory by 365, and divide the result by your total annual cost of goods. The result tells you how many days it takes your business, on average, to sell an item.

Joe’s has $75,000 of inventory on an average day and annually spends $300,000 purchasing goods. Its merchandise typically takes 91 days to sell.

Here’s what happens to cash down at Joe’s Garage. The business buys an item, say an automotive part, on day 1 and pays for it on day 23. Then a customer comes in and has the part installed on day 91, taking an additional 44 days to pay the bill. Put it all together, and there’s a yawning 112-day gap between when Joe’s pays for an item and when it gets paid. Joe’s likely has a whopping cash-flow problem, perhaps having to borrow money to get through its nearly four-month wait to get paid.

Once you’re tracking your ratios, work to improve them. For instance, asking vendors for longer terms, buying faster-turning merchandise, and cracking down on slow-paying customers can all work to narrow your cash gap. Ideally, you’ll achieve a virtuous cash cycle in which you pay vendors after customers pay you.