The adage “Cash is King” is true for business at any time; however, during challenging economic times the king’s reign can seem particularly taxing. Businesses are feeling many constraints, including decreased sales, tightened margins, and increased labour costs. On top of this, interest rates continue to rise, making additional debt less appealing. Managing cash flow can seem like a daunting prospect.
Regular focus on key indicators of the business can help alleviate some of the pressure, but the most challenging part for any business is having the discipline to monitor these factors on a regular basis. We recommend picking six or seven key metrics and looking at them monthly. Having a meeting with key staff members to review these can generate ideas on improvement. For most businesses, we recommend looking at the following metrics on a regular basis:
- Gross Margin (%)
- Inventory Turns (or weeks of supply)
- Days Sales Outstanding (Accounts Receivable)
- Days Payable Outstanding (Accounts Payable)
- Cash Conversion Cycle
- Current Ratio
- Debt to Equity Ratio
- Debt Service Coverage Ratio
Let’s look at some of these metrics, and some business strategies for improving cash flow, in more detail.
Optimize Your Working Capital
Many businesses have cash tied up in working capital. In addition to cash itself, working capital includes inventory, accounts receivable, and accounts payable. Optimizing these three levers can free up cash without affecting the income statement. With each of them, it is important to look at industry standards and try to keep your company’s performance at or better than the averages. There are many sources for industry averages, but I like to use Ready Ratio’s debt-to-equity ratio reports.
Inventory
Inventory can be managed by looking at weeks of supply or inventory turns. Weeks of supply is calculated by dividing your inventory by the average weekly cost of goods sold. This will tell you how many weeks of supply you have on hand of your total inventory, or even of a particular product. Inventory turns use the same numbers to come up with the amount of times your inventory will cycle in the course of a year. This is calculated by dividing your annual cost of goods sold by your average monthly inventory.
Equations
Weeks of supply = (inventory / average weekly cost of goods sold)
Yearly inventory cycle = (annual cost of goods sold / average monthly inventory)
Accounts Receivable
Most businesses that aren’t in the retail industry extend payments to their customers. This creates accounts receivable, or money that is owed to your business. Your business will often need to extend terms to get revenue from customers, so it is best to negotiate the shortest possible terms with them. During hard economic times, many customers may slow down on payments. Remember that “the squeaky wheel gets the grease.” We suggest that, when a customer is a couple days late, you send them a polite reminder. After a week, give them a call to follow up. If payments are delayed too much longer, consider stopping services until everything is caught up.
Accounts Payable
The inverse of accounts receivable is accounts payable. Just like you do for your customers, many of your suppliers may extend terms for you. Work with as many of your suppliers as possible at creating payment terms. If you can use their money as opposed to borrowing from the bank, it is a cheaper way to increase your cash flow.
The Cash Conversion Cycle
The combination of these three metrics is called the cash conversion cycle. This cycle indicates how many days of cash are tied up in the process of a sale. The shorter the cash conversion cycle, the better you are utilizing your cash. The cycle can be calculated by taking the number of days of inventory (or weeks of supply multiplied by seven), plus the days of accounts receivable, minus the days of accounts payable. It is possible with heavy negotiation to get a negative cash conversion cycle. In these rare cases, cash can be received before anything is spent on a sale.
Equation
Cash conversion cycle = (number of days of inventory) + (days of accounts receivable) – (days of accounts payable)
Revenue & Increasing Efficiency
Outside of working capital, there are several other areas you can focus on in order to optimize cash flow.
Revenue
Driving revenue is always the quickest way to increase cash flow, and continuing to utilize marketing is the best way to ensure revenue continues. During challenging times, appeal to your customers by reminding them of the benefits to purchasing your product. Businesses often start decreasing their marketing budget when times are tough, which can lead to a cycle of decreased sales. Instead, hone in on your marketing and make sure it is resonating with your customers. Watch your return on investment (ROI) to ensure your marketing is performing as expected.
Operations
Continuously looking for ways to increase efficiency will free up cash by lowering your expenses. If you’re in manufacturing, look for ways to maximize your recipes or bills of material. Are there ways you can decrease waste without affecting quality? Is your labour being used as efficiently as it can?
Equipment
It may sound counter intuitive, but looking for equipment that will increase efficiency is often a great way to optimize your long-term cash flow. The cost of a new machine may quickly make up for the cost of labour. Manufacturers often offer leases with little-to-nothing down, and these leases may have better terms than additional loans. That said, if you do need to borrow money, try to get a fixed interest rate. If rates decrease in the future, you can always refinance.
We Can Help
It can be challenging even to identify what key metrics to focus on, or which strategies could be the most effective for improving your business’ cash flow. If you need help creating and managing a growth strategy, please contact Axios Growth Consultants. We offer an initial evaluation and can create a long-term program that keeps your company focused on growing, even during challenging economic times.