- 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 to operating cash flow
Latest news – Did you hear about the company that tried to survive on loans and debt alone?
Spoiler alert – It didn’t go so well. Let’s accept, businesses cannot survive by paying their employees with IOUs and empty promises!
So depending on loans or debt to finance your company’s operations without generating adequate cash inflow can lead to financial challenges. So, tracking your operating cash flow, or the money you generate from your business’s primary operations (e.g. refining and selling petroleum products for an oil refinery), is crucial to ensure the organization’s survival and sustainability.
Think of it as a ‘cha-ching,’ that keeps your daily operations running smoothly.
What is operating cash flow?
Operating cash flow is the cash or net income generated from a business’s primary operations and covers items such as wages paid, the money paid to suppliers, cash received from customers, overhead charges, and any non-cash items such as depreciation. It is key to keeping a business’s day-to-day activities running.
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.
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, 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
Here are 10 key operating cash flow metrics and KPIs that businesses should track regularly:
- Days sales outstanding (DSO)
- days payable outstanding (DPO)
- Accounts receivable turnover (ART)
- Accounts payable turnover (APT)
- Current ratio
- Free cash flow (FCF)
- Cash flow coverage ratio (CFCR)
- Cash conversion cycle (CCC)
- Operating cash flow margin
- Forecast variance
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 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 ratioindicates 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.
How to pick financial KPIs that are suitable for your business?
With several metrics & KPIs to track operating cash flow efficiency, as a finance leader, you’ll need to choose the right ones for your business to optimize resources, including FTE time and effort. This can be challenging, though.
Here are some tips to help you choose the right cash flow metrics that are best for your business:
Don’t measure everything:
Trying to track all the financial metrics will only leave you confused and not focused on the most important ones. Choose the metrics that you want to track based on your business goals and the impact that your business is trying to create.
For example, if reducing debt by 50% in the next two years is your goal, you should track FCF, current ratio, and FCFR.
Assess if the chosen KPIs are providing the full picture:
Once you select a set of operating cash flow KPIs to track, assess periodically if they are providing you with a full picture of what you want to know.
If not, then study which metrics need to be added and which ones can be dropped from your tracker or dashboard. Based on changes in your business goals, you’ll need to reassess if you are tracking the right operating cash flow metrics.
Engage third-party finance and accounting (F&A) consultants:
If you are a small or mid-sized business without sufficient resources or expertise in the finance domain, consult with third-party experts to set up trackers and dashboards that’ll help you track the most relevant F&A metrics to your business.
Automate the process with software solutions:
ERP systems, accounting tools, accounts receivable automation solutions, etc., help you integrate data from multiple locations and track the most relevant cash flow metrics and KPIs. Automation tools provide real-time data and visual representation of key metrics and their trends.
Next steps: Use a dashboard to track operating cash flow metrics
Remember, just like how you need water to survive, your business needs cash to thrive. Make sure to keep your cash flow in check, or your business might end up drier than the Sahara!
Cash flow is of prime importance to all businesses. Even a small error in tracking the KPIs and metrics related to operating cash flow can lead to cash crunches, debt issues, and even bankruptcy.
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.
Talk to us and catch a glimpse of how we can help your business track the right metrics and optimize your finance operations with AI-powered software.
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.
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.
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.
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.
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.