Businesses cannot survive without cash. Using loans or debt alone 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.
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 keep a business’s day-to-day activities running.
Here’s an example of how to calculate operating cash flow using 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.
In this section, we look at ten key operating cash flow metrics and KPIs that businesses should track regularly.
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 the 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.
Read our blog to know more about DSO and its role in optimizing AR and cash flow.
DPO can be considered the opposite or reverse of DSO. It is the average number of days a business takes to pay its suppliers.
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 a very high DPO 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.
Accounts receivable turnover ratio provides insights into a business’s collection efficiency. It is the ratio of net credit sales to average accounts receivable for a given time period.
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.
Accounts payable turnover ratio, also called creditor’s turnover ratio, is a measure of short-term liquidity and indicates the number of times a company pays its creditors or suppliers in a given time period.
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.
Current ratio, also known as working capital ratio, is the ratio of current assets to current liabilities. It is an indicator of a business’s ability to pay off short-term liabilities.
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. A current ratio of 2 means that the company has twice the amount of cash or assets needed to pay its short-term liabilities.
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.
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.
The CFCR ratio indicates whether a business has the ability to pay its debts with the cash flow from operations. It is the ratio of cash flow from operations to the total debt.
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.
Cash conversion cycle, also known as 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.
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 is able to collect payments faster and has more liquidity.
Operating cash flow margin is a metric used to measure a business’s profitability and the quality of its earnings. It is the ratio of operating cash flow to the total sales revenue in a given period.
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.
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.
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 using 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.
With several metrics to track operating cash flow efficiency, 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 best cash flow metrics for your business.
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.
Use dashboard tools to track the metrics for operating cash flow in real-time. Such dashboards are available in software solutions such as accounting or receivables management software.
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.
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.
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.
The factors that affect operating cash flow include sales, inventory, accounts receivable, accounts payable, and non-cash expenses such as depreciation and amortization.
Operating cash flow metrics are used to benchmark the financial strength of a business and track how much cash it is able to generate from its day-to-day operations.
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