Key Takeaways
- Operating cash flow is the cash generated from a business’ primary operations and is crucial to ensure the organization’s survival and sustainability.
- Key performance indicators (KPIs) and metrics for operating cash flow, such as DSO, DPO, ART, APT, and others, should be closely monitored to ensure there is enough cash to run daily business operations.
- Benchmarking your operating cash flow metrics against industry standards is crucial to get an accurate picture of how your business is performing.
Introduction
Managing cash flow effectively is crucial for the financial health and sustainability of any business. It ensures the availability of funds to cover daily operations, pay suppliers, and invest in future growth. To effectively monitor and optimize cash flow, businesses rely on key performance indicators (KPIs) and metrics specific to operating cash flow.
These indicators provide valuable insights into the efficiency of a company’s cash management practices and offer a comprehensive view of its financial performance. Selecting the right set of cash management metrics is crucial for businesses as it allows them to focus on the most impactful indicators that align with their specific goals and objectives.
In this article, we will explore 10 essential operating cash flow metrics and KPIs that every business should regularly track. By understanding these metrics and how they impact cash flow, finance managers can make informed decisions to optimize resources and improve profitability. So, let’s dive in.
What Is Operating Cash Flow?
Operating cash flow (OCF) is a measure of the cash or net income generated from a business’s core operations, encompassing wages, supplier payments, customer receipts, overhead charges, and non-cash items like depreciation. It plays a vital role in sustaining day-to-day business activities.
Operating cash flow calculation
Now we could simply put up the formula to calculate operating cash flow, but what’s fun in staring at a bunch of equations?
So, to calculate the operating cash flow, let’s take a real-life example of the 2022 annual report of Salesforce.
Here,
Net income = $1,444
Non-cash expenses = $3,298 (depreciation costs) + $1,348 (amortization of revenue contract costs) + $2,779 (stock-based expenses) + ($1,211) (gains on strategic investments) = $6,214
Current assets = $1,824 (net AR) + $2,283 (costs capitalized for revenue contracts) – $114 (prepaid expenses) = $4,107
Current liabilities = $507 (AP) + ($801) (operating liabilities) + $2,629 (unearned revenue) = $2,449
Increase in working capital = Current assets – current liabilities = $4,107- $2,449 = $1,658
Operating cash flow = Net income + non-cash expenses – increase in working capital = $1,444 + $6,214 – $1,658 = $6,000
Operating cash flow = Net income + non-cash expenses – increase in working capital
Operating cash flow, thus, includes several components, of which accounts receivables (AR) and accounts payables (AP) form a crucial part. Finance teams must keep a close tab on the key performance indicators (KPIs) and metrics for operating cash flow to ensure there is enough cash to run the daily business operations.
In the next section, we will dive deeper into the key operating cash flow KPIs and metrics that every finance manager should keep a tab on.
Key Operating Cash Flow KPIs and Metrics
By tracking the key operating cash flow metrics and KPIs, businesses can identify areas for improvement, optimize resources, and make informed decisions to enhance their operating cash flow. Here’s our list of the key operating cash flow metrics that businesses should track:
1. Days sales outstanding (DSO)
DSO reflects the average number of days a business takes to collect payments after a credit sale has been made.
DSO = (Average receivables in a given period/total credit sales in the same period) x number of days in the period
A low DSO means that your cash conversion cycle is short, and you can collect your dues from customers faster. A high DSO may indicate poor collection practices and cash flow issues.
DSO values vary from industry to industry based on prevalent sales practices. Hence benchmarking your DSO against industry standards is crucial to get an accurate picture of how your collections are faring.
For example, the DSO for the mining support industry is 91 days, while it is only 67 days for the civil engineering construction industry.
2. days payable outstanding (DPO)
DPO is the average number of days a business takes to pay its suppliers. It can be considered the opposite or reverse of DSO.
DPO = Accounts Payable * the number of days / Cost of goods sold
Cost of goods sold = Beginning inventory + purchases – closing inventory
A higher DPO indicates that you are able to keep cash in hand for longer and invest it in the short term for better returns but it can also imply that you risk losing good credit terms in the future.
A low DPO often indicates that your business is not taking advantage of the credit terms offered or is not negotiating for better terms. Similar to DSO, DPO also varies from industry to industry.
3. Accounts receivable turnover (ART)
Accounts receivable turnover ratio is the ratio of net credit sales to average accounts receivable for a given time period. It provides insights into a business’s collection efficiency.
ART = Total credit sales/ Average accounts receivables
The accounts receivable turnover ratio can be considered a measure of the number of times a company’s receivables are converted into cash in a given time period. This ratio is also known as the debtor’s turnover ratio.
A higher ART indicates that a company is good at collecting receivables. A low ART either means that the company has difficulty collecting from its customers or is offering clients payment terms that are too lenient.
4. Accounts payable turnover (APT)
Accounts payable turnover ratio indicates the number of times a company pays its creditors or suppliers in a given time period. It is also called the creditor’s turnover ratio and is a measure of short-term liquidity.
APT = Total credit purchases/ [(Starting accounts payable + Ending accounts payable)/2]
A higher APT indicates that your company may not be effectively using your credit terms, or your suppliers may not be extending favorable credit lines. A lower APT suggests that you are using your credit lines effectively; but a very low APT, like a low DPO, can cause friction in your relations with suppliers.
5. Current ratio
The current ratio is the ratio of current assets to current liabilities. It is also known as the working capital ratio and is an indicator of a business’s ability to pay off short-term liabilities.
Current ratio = Current assets (includes accounts receivables) / current liabilities (includes accounts payable and accrued expenses)
A higher ratio indicates that the business can repay its short-term loans easily. A low ratio suggests that the business may have trouble paying its upcoming bills. So, the chance of open invoices turning into bad debt is higher for customer accounts with a low current ratio.
A current ratio between 1.5 – 3 is generally considered healthy. For example, a current ratio of 2 means that the company has twice the amount of cash or assets needed to pay its short-term liabilities.
6. Free cash flow (FCF)
Free cash flow represents the money available to a business to repay its creditors and pay interest and dividends to investors. It indicates the cash available to a business after paying short-term liabilities and investing in the necessary operational equipment.
Free cash flow = Operating cash flow – capital expenditures
A high FCF indicates that the company has good operating cash flow and excess cash to make further investments, pay off debts, or pay dividends to shareholders.
7. Cash flow coverage ratio (CFCR)
The CFCR ratio is the ratio of cash flow from operations to the total debt. It indicates whether a business has the ability to pay its debts with the cash flow from operations.
CFCR = [Cash flow from operations/total debt] * 100
A high CFCR indicates that the company is in a good position to pay its debts. The cash flow coverage for businesses should be at least 1.5x. A CFCR of 1.5 indicates that the company has $1.5 in operating cash flows to pay $1 of interest payments.
If the cash flow coverage ratio falls below 1.5, it may suggest that the company has poor debt management practices or that it is struggling to make interest payments on time.
8. Cash conversion cycle (CCC)
Cash conversion cycle, also known as a net operating cycle or cash cycle, measures how long a company takes to convert its inventory and investments to cash. It is measured in days.
Cash conversion cycle = Days inventory outstanding + average collection period (DSO) – DPO
It is a measure of how long every dollar invested in production and sales processes takes to get converted into cash payments. It takes into account how much time the company takes to sell its inventory, collect receivables, and pay its bills.
A lower CCC indicates that the company can collect payments faster and has more liquidity.
9. Operating cash flow margin
Operating cash flow margin is the ratio of operating cash flow to the total sales revenue in a given period. It is a metric used to measure a business’s profitability and the quality of its earnings.
Operating cash flow margin = (Cash flow from operating activities / net sales) * 100
A positive percentage indicates good profitability and operational efficiency. A negative percentage indicates that the company is losing money. Cash flow margin can be used to compare businesses within the same industry.
Timely collections can help have a strong operating cash flow margin. Companies that have an operating cash flow margin above 50% are considered to have a strong cash flow.
10. Forecast variance
forecast variance measures the difference between your cash forecasts and the actual outcome. Businesses track the variance between their cash flow forecast and the actual cash flow to understand how accurate their estimates are.
Forecast variance = (Actual outcome – Forecast value) / (Forecast value) * 100
Tracking forecast variance over a period helps you improve your forecast models and make better business decisions.
A higher forecast variance indicates that you are not likely to use the right variables in your model or that your forecast model needs a different set of input parameters. A lower forecast variance shows strong predictive capabilities and better decision-making abilities.
Next Steps: Use an A/R Tracking Software to Positively Impact Your Cash Flow
Managing accounts receivable (A/R) is a critical aspect of cash flow management for businesses. A/R tracking software can help businesses streamline their invoicing and payment processes, reducing the time it takes to collect payments and improving cash flow. By automating the A/R process, businesses can also reduce errors and improve accuracy, which can further improve cash flow.
Manually tracking operating cash flow metrics is tedious and doesn’t provide you with real-time updates. Relying on poor-quality data to track operating cash flow KPIs can affect your business’s day-to-day operations as well as investment plans. It will also lead to unhappy stakeholders.
At HighRadius, we offer autonomous solutions powered by AI to streamline and optimize accounting, accounts receivable management, and treasury operations. Schedule a demo and catch a glimpse of how we can help your business track the right metrics and optimize your finance operations with AI-powered software.
FAQs
1. What is a good cash flow ratio?
A cash flow ratio greater than one indicates good financial strength. A ratio lower than one suggests that the company may have trouble repaying its short-term liabilities. A higher cash flow ratio is, thus, considered better.
2. Is cash flow the same as operating cash flow?
Operating cash flow refers to the amount of cash generated from a business’s primary activities. The total cash flow includes operating cash flow as well as the money generated from other activities such as investing and financing.
3. What is the operating cash flow ratio?
The operating cash flow ratio equals cash flow from operations divided by current liabilities. It tells how many times a company can pay off its short-term debts with the cash generated in the same period.
4. What affects operating cash flow?
The factors that affect operating cash flow are sales, inventory, accounts receivable, accounts payable, and non-cash expenses such as depreciation and amortization.
5. Why is operating cash flow important?
Operating cash flow metrics are used to benchmark the financial strength of a business and track how much cash it can generate from its day-to-day operations.
6. What is KPI in cash management?
Cash management KPIs evaluate the effectiveness and performance of cash management practices within a business. They provide insights into various aspects, such as liquidity, cash flow efficiency, working capital management, and risk exposure.
7. How do you measure cash management efficiency?
Cash management efficiency is measured through metrics like cash conversion cycle, days sales outstanding, accounts payable days, cash to cash cycle time, and cash flow forecast accuracy. By tracking these metrics, businesses can identify areas for improvement to optimize cash flow.
