In a recent study by TD Bank Financial Group it was determined that one of the primary challenges facing small business was cash flow (The other two were managing clients and government red tape). This probably comes as no surprise to most small business owners, especially in the early stages. The simple answer to this problem would be a limitless source of cash. (Of course if we had unlimited funds, we may not find it necessary to endure the trial and tribulations of business ownership). Since this is usually not possible, we need to do the next best thing: analyze our cash flow requirements and find the most cost effective and easily available solution for any shortfalls. Even the most successful business can find itself shutting its doors if it is not able to manage it's cash flow needs.
Below are 4 financial metrics, which if understood and monitored regularly, can actually help improve your business' cash flow:
Gross margin (aka Gross Profit)
The amount that remains after all the direct costs (also known as cost of goods sold or COGS) are deducted from the total sales represents the gross margin. This can be expressed as an amount or as a percentage of sales. Examples of direct costs for a jewellery maker include the cost of the gold, diamonds and manufacturing salaries. Gross margin is important as it helps to establish the breakeven point i.e. the number of sales required to cover all costs.
How it can increase cash flow: Comparison of gross margin to others in the industry, can help you determine if you are charging enough (or too much ). Alternatively, if you find that you have to sell an unreasonable amount to break even, then it may be time to tweak your pricing strategy.
Net Profit (Loss)
The amount left over from your sales after deducting all of your expenses including your direct costs as well as overhead (salaries, rent, insurance etc.) represents your profit. If your expenses exceed your sales, then you have a loss. Losses are common for startups, and are ok, as long as you have a plan for when you expect to be profitable. Of course, it is important to calculate your net profit on a regular basis.
How it can increase cash flow: Net profit lets you know if your business is on track for optimum profitability. If your net profit is low or if you are incurring a loss, depending on your expectations and existing cash flow situation, it helps to highlight expenses that need to be reduced or eliminated. For example you may decide to travel less, or change your marketing strategy, thereby improving your net profit, and consequently your cash flow.
Days Sales Outstanding (DSO)
DSO represents the amount of time it takes to collect accounts receivable. The calculation is as follows:
*Accounts Receivable/Credits Sales X # of days in reference period (eg. 30 days)*
The lower the result, the lower the collection period, the better it is for your cash flow.
How it can increase cash flow: If your customers have terms of 30 days, but your DSO is 42 days, it is negative for your cash flow. If this is the case, then you need to take steps to ensure that you are able to collect your accounts receivable more quickly. By implementing measures to improve accounts receivable collection, you can improve your cash flow quickly and potentially significantly.
The number of days it takes to sell the inventory on hand is represented by the Days Inventory and is calculated as follows:
* Cost of Goods Sold (see above)/InventoryX# of days in reference period*
As with DSO, the lower the result, the better it is for your bottom line.
How it can increase cash flow:Inventory can be a significant investment. Many companies buy too much inventory thereby reducing their cash flow , as well as incurring unnecessary storage costs. By understanding how quickly you are turning over your inventory, you can make more optimal buying decisions, which can have a direct impact on cash flow.
There are a number of financial analyses that can help a small business owner better understand their business, and directly or indirectly improve profitability and cash flow. Of course this requires a timely and accurate accounting system, and a good understanding of financial statements. Understanding the financial position of the company, and reacting accordingly, can be the difference between being a successful business and the next Pets.com.
About the author: Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. Please sign up to receive articles pertaining to small business, accounting, tax and other occasional non business topics of interest. You can also follow her on Facebook or Twitter.