If you ever find yourself asking the question “how can I improve the cash flow of my business?”, then read on, as this post dives into the specific drivers that impact the cash flow of your business.
If you have a business, you likely know by now that it’s good to have a goal of having consistent positive cash flow. And while goals are important to establish, it’s the drivers behind the goals that are important to understand, as these are the specific levers you can pull to move the needle on your overall goals.
So, when it comes to cash flow, what are the specific drivers, the levers that you can pull, in order to move the needle toward having consistent positive cash flow?
Let’s go through a few of them here:
Profitability
You can have great cash flow initially, but if your business is not profitable it’s not sustainable and it will bleed cash. So, what drives profitability? Essentially it’s your revenue and your expenses. We’ll go through each in more detail.
You need to have revenue in your business. In our 6 Ways To Drive Your Revenue online course we dive into the specific drivers of your revenue, and how you can directly impact them. For the purpose of this article, we’ll list the drivers here.
Leads
Conversion Rate
Retention Rate
Referral Rate
Number of Transactions per Customer
These are the levers that you can pull to drive your revenue.
Now that you’ve got a better understanding of what drives revenue, let’s look at your Cost of Goods Sold, or Cost of Sales. These are the costs that are specifically related to your products or services. If you’re selling a service, it’s the direct labour or contractor hours and related costs associated with that service. If you are selling a product, it’s the cost of your inventory for those sales.
A good metric to track when it comes to your Cost of Sales is your Gross Margin, which is calculated as follows:
(Revenue – Cost of Sales) ÷ Revenue = Gross Margin
This is a percentage, which lets you know how much of every dollar from your sales you have as profit to cover your overhead expenses or draw as income from the company.
For example, if your gross margin is 60%, that means for every dollar in sales that you have, there is 60 cents available to cover your overhead and profit, and 40 cents goes toward the direct costs related to your sales, such as inventory or direct labour hours.
Now that you understand your Gross Margin, your business has overhead expenses to cover. These are expenses like marketing, payroll, subscriptions, travel expenses, vehicle expenses, rent or office expenses. These are all costs that are important to keep your business running, so that it can sell the products or services that it sells.
Your overhead expenses are subtracted from your gross profit to get what is called your Net Income.
Revenue – Cost of Goods Sold – Overhead Expenses = Net Income
This is your take home income. If you divide that number by your overall revenue, that gives your Net Profit Margin as a percentage.
Net Income ÷ Revenue = Net Profit Margin
You can use that percentage to determine how much profit you take home after every dollar of sale.
For example, if you have a net profit margin of 20%, that means that for every dollar in sales that your business does, you can take home 20 cents after paying all the expenses within your business.
So, revenue, cost of sales and overhead expenses are all drivers of your profitability, and it is important to understand these drivers, in order to better understand your profitability.
Your overall profitability is a very important driver of cash flow. You can be making sales all day long, and even getting cash in the door quickly, but if you aren’t profitable, your business will eventually bleed cash.
Now that we’ve covered profitability, let’s dive into some of the other drivers of your cash flow.
The next 3 drivers we’ll cover are used to determine what is called your Cash Conversion Cycle, which will be defined further in this article.
Days Sales Outstanding (DSO)
The first of these 3 drivers is how long it takes to collect payment on your sales. This is called your Days Sales Outstanding. If you collect cash on all your sales, this will be zero, as you’ll have no outstanding invoices that you are waiting for payment on. If it normally takes 30 days to get paid for all your sales invoices, then your Days Sales Outstanding will likely be around 30 days. The longer your Days Sales Outstanding, the longer your cash flow cycle will be, so you want to keep this tight.
Your DSO is calculated as follows:
Days Sales Outstanding = Average Accounts Receivable ÷ Revenue x 365 Days
Where Average Accounts Receivable (AR) for a given period is equal to the beginning AR balance plus the ending AR balance divided by 2.
Days Inventory Outstanding (DIO)
The second is how long it takes to sell your inventory or, if you have a construction business, how long it takes to bill out your Work in Progress, or your WIP. This is called your Days Inventory Outstanding. If it usually takes you 15 days to sell your inventory once you have it, then your Days In Inventory is 15 days. If you have a construction business and aren’t necessarily on top of billing for all of your time and materials, it’s possible this number may be more around the 30 to 45 day mark, sometimes longer. The longer it takes to sell or turn over your inventory, the longer your cash flow cycle will be, and so you want to keep this as tight as possible as well.
Your DIO is calculated as follows:
Days Inventory Outstanding = Average Inventory ÷ Cost of Goods Sold x 365 Days
Where Average Inventory for a given period is equal to the beginning Inventory balance plus the ending Inventory balance divided by 2.
Days Payable Outstanding (DPO)
The third driver impacting your Cash Conversion Cycle is how long it takes to pay your vendors. This is called your Days Payable Outstanding. If you pay everything by bank card on the spot, then this will be zero. If you have credit accounts with suppliers that you pay off in 30 days, or if you pay for everything on a credit card which you typically pay off within a month, then your Days Payable Outstanding may be around 30 days. The longer it takes to pay your vendors, the shorter your cash flow cycle, and so you generally want to extend this. Of course, you also want to maintain strong relationships with your vendors, and so don’t overextend this to the point that you start making your vendors unhappy.
Your DPO is calculated as follows:
Days Payable Outstanding = Average Accounts Payable ÷ Cost of Goods Sold x 365 Days
Where Average Accounts Payable (AP) for a given period is equal to the beginning AP balance plus the ending AP balance divided by 2.
These last 3 drivers we just covered, Days Sales Outstanding, Days Inventory Outstanding, and Days Payable Outstanding, these can be used to calculate your Cash Conversion Cycle. This is calculated as follows:
Cash Conversion Cycle = Days Sales Outstanding + Days Inventory Outstanding – Days Payable Outstanding
Knowing your Cash Conversion Cycle can be helpful in determining the cash reserves that you should set as a target for your business to maintain smooth operations. If you click here you can download a simple excel tool to calculate the Cash Conversion Cycle of your own business.
Now let’s go through a few remaining cash flow drivers.
Purchase/Sale Of Assets
The next is the purchase or sale of any assets in your business. This can be assets that may be considered prepaid assets, such as your insurance policy for example, or the purchase of longer-term assets, such as equipment. This will be a draw down on your cash. If you sell any of your assets, which is quite common in business (for example, you may have some equipment that you no longer use and so you decide to sell it), this will result in an increase in cash in your business.
Additions To/Payments Of Debt
Another driver is going to be related to debt. If you take any debt on in your business, that will increase your cash at that time. You will then have debt servicing obligations which will result in a decrease in cash over time. These debt servicing obligations are typically going to be a combination of principal repayments as well as interest payments, depending on the terms of the financing. If you are considering any debt financing for your business, it is a good idea to look at the terms, and negotiate terms that will be as beneficial for your cash flow as possible.
Shareholder Contributions/Draws
The last cash flow driver we’ll discuss here is related to you, the business owner. Sometimes when a business is in a cash constraint, the owner may inject some of their own cash into the business, which will bump up the cash flow; though this is not a good rhythm to maintain for a prolonged period, unless it is for a very strategic reason that you should discuss with your financial guide, whether that be your in-house finance lead, or your accountant or your virtual CFO. The other side of this is draws from the company by the owner, whether it be in the form of a loan or as dividends taken out of the company. These injections or draws also impact the cash flow of the company.
To summarize, here are some specific drivers you can focus on in your business in order to optimize your cash flow.
Revenue
Leads
Conversion Rate
Retention Rate
Referral Rate
Average $ Per Transaction
Number of Transactions per Customer
Cost of Sales
Overhead expenses
Days Sales Outstanding
Days Inventory Outstanding
Days Payable Outstanding
Purchase or sale of any assets
Additions or repayments of any debt
Cash injections into or draws from the business by the owner
The next step in understanding these drivers is to know these numbers in your own business. Know how they change month over month, understand how they may compare to the industry that your business is in, monitor and compare these to your overall targets or goals, and then act on them specifically to improve your cash flow. This is a disciplined approach that can have a huge impact on the cash flow of your business. If you need a guide to help you with this on an ongoing basis, this is one of the key areas that we focus on with our virtual CFO services.
There’s quite a lot that we covered here, and each driver can be its own topic to dive into specifically. If you have any questions about any of these, please reach out, or click here to schedule a Zoom call to discuss how we can help you improve the cash flow of your business.
People often enter into business because they are good at what they do, but face challenges as their business grows. At BasePoint CPA, we serve as your experienced financial guides, so you can have confidence with regular financial insights and the ability to make informed strategic decisions.
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The information above is intended to be of a general nature, and is not intended to address the circumstances of any particular individual or entity, and is not able to capture changes that may be enacted that would impact the information above following the date of publication. As such, there is no guarantee that the information above is accurate as of any given date following publication, and so no one should act on or make specific decisions based on the information above without first receiving professional advice that can take into consideration specific circumstances for each person. Should you wish to discuss your specific situation, you can contact us here.
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