4 Metrics to Help Improve Your Small Business Cash Flow

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. 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:

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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 variable and fixed costs.

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.

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 reduce the amount you are spending on marketing, Alternatively, you might need to find ways to increase sales or charge higher prices.

Days Sales Outstanding (DSO)

DSO represents the amount of time it takes to collect accounts receivable owing from customers.  The calculation is as follows:

*Accounts Receivable/Credits Sales X # of days in reference period (eg. 30 days)*

A low result, relative to previous periods, or compared to competitors is better for cash flow as it means that it takes less time to collect amounts owing by customers which directly adds to the cash balance of the business.

One way to look at this is 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.

Days Inventory:

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.

Inventory can be a significant investment.  Many companies buy too much inventory thereby reducing their cash flow upon purchase and also incur 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.  Ensuring that you are monitoring your cash flow situation regularly is an essential component of most successful businesses.

Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.

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