Cash is King. Understanding Cash is vital to business success.
According to data from the Bureau of Labor Statistics, as reported by Fundera, approximately 20 percent of small businesses fail within the first year. By the end of the second year, 30 percent of businesses will have failed. By the end of the fifth year, about half will have failed. And by the end of the decade, only 30 percent of businesses will remain — a 70 percent failure rate.
The number one reason most businesses fail? A lack of capital, investors, or funding. In other words, they don’t have cash.
As a financial advisor, part of your job is teaching and communicating with your clients. You are more than a report generator, number-puncher-inner, and tax preparer. Educating clients not only helps them but helps you as well. They become more versed in how the finances of a business run, which in turn can make their chances of success skyrocket. And you get a grateful client for life because you help your client make data-driven decisions.
Key Cash Metrics
Three of the top cash monitoring metrics are Cash Flow, Net Cash Flow, and the Cash Conversion Cycle. I am sure you could argue for other metrics, but we will stick with these three for this article.
Cash flow is the money that is moving (or flowing) both in and out of your business. The total amount of money being transferred into and out of business primarily affects liquidity.
The cash flowing into your business comes from your customers and clients buying your products or services. If your customers pay with an invoice after the purchase, a portion of cash flow is coming from accounts receivable.
The cash flowing out of your business is payments for expenses. Examples are things such as; rent or a mortgage, monthly loan payments, and payments for taxes and other accounts payable.
Why is understanding cash flow important?
Businesses can make the most prudent financial decisions by having an accurate and up-to-date cash flow statement. Cash flow shows you the exact amount of funds you have available at any given time.
This information helps you help your clients trim their financial sails.
How to Analyze Cash Flow
A cash flow statement looks at the change to cash from different business activities and increases or decreases in other accounts on the business balance sheet.
The best way to keep track of cash flow in your business is to run a cash flow report monthly. An easy-to-read report can make all the difference in understanding your business cash flow.
Net Cash Flow
Net cash flow is closely related to Cash Flow (obviously!). It is the difference between a company’s cash inflows and outflows in any particular period. In the most strict sense, net cash flow refers to the change in a company’s cash balance as detailed on its cash flow statement. It is important to note that net cash flow is not the same as net income, free cash flow, or EBITDA.
Net cash flow is comprised of three forms of activities, which are:
- Operating activities – Operating activities are cash generated and used by the basic operations, such as cash receipts from customers and expenditures for the cost of goods sold and administrative expenses.
- Financing activities – Are cash received through a debt agreement or cash issued to pay off a debt, repurchase company shares, or pay out a dividend.
- Investment activities – Can be cash received from a gain on investment or cash issued to buy an investment instrument or purchase fixed assets.
By quickly creating visual metrics with Reach Reporting you can help businesses succeed with visual financials.
How to Calculate Net Cash Flow
You can approximate a company’s net cash flow by looking at the period-over-period change in cash on the balance sheet. But the statement of cash flows is the ideal place to look. Use the flowing formula to calculate.
Net Cash Flow = Net Income + Gains & Losses from financing & investments + Non-cash charges + changes in operating accounts
Why Understanding Net Cash Flow is Important
Net cash flow is a company’s money to expand and grow, develop new products, or reduce debt. Frequently Net Cash Flow is considered the most important financial indicator above and beyond all others because it is an excellent indicator of its core operations. It can help an investor gauge its functions and see whether the core operations generate ample money in the business.
Cash Conversion Cycle
The cash conversion cycle (CCC), also known as Cash Cycle or the Net Operating Cycle, measures the time it takes for a business’s investments to become sales and then into revenue. This metric accounts for the time it takes to move inventory, get paid, and pay debts without incurring additional fees or interest. CCC is commonly measured in days.
How to calculate CCC
Calculating CCC comes down to one formula:
CCC = DIO + DSO – DPO
While the formula looks relatively simple, don’t be fooled, it can be complicated. Check out a breakdown of it:
- CCC (Cash Conversion Cycle)
- DIO (Days of Inventory Outstanding): The average number of days needed to clear the inventory.
- DSO (Days of Sales Outstanding): The average number of days needed to collect payment after a sale.
- DPO (Days Payables Outstanding): The average number of days it takes a company to pay its bills.
You can find all the numbers needed to use the CCC formula on the business’s financial statements. Remember, only work the numbers from the given time.
- The set number of days or periods for this article you are measuring
- Total revenue and cost of goods sold
- The total inventory in the beginning and end
- How many receivables the company has at the beginning and end
- How much the company owes at the beginning and end.
Why is CCC important
The cash conversion cycle is essential to understand for two reasons. First, it’s an indicator of the company’s efficiency in managing its important working capital assets. Secondly, it provides a clear view of a company’s ability to pay off its current liabilities.
These three key metrics are where the proper understanding of the role cash play.
When your clients understand these metrics and how cash plays into their long-term success, the sky is the limit for financial gain.