As is often the case, this week’s newsletter was inspired by a recent conversation with a business owner. It was a conversation and response I received far too often. The shortened version went like this:
Biz Owner: “ I don’t need management accounts or KPIs. I have been going 10 years and have done OK without them”.
Me: “How do you manage your cash flow?”
Biz Owner: “Simple. I look at the bank balance every day.”
Now this business had done pretty well, BUT luck has played a fair part in getting this far, with his only measure of analytics being the cash in the bank today. It could all come crumbling down very quickly in the future, and finally, imagine how much better they could have done if they had properly invested in their finance function.
Nobody can successfully manage the cash flow of their business by just looking at their bank balance!
There are two reasons business owners struggle with managing their cash. The first is you must have a cash flow forecast that is managed and up to date (most don’t), and the second is you need to understand what you have vs what you owe - this is information that comes from your balance sheet, a report that very few owners look at or understand.
This post will walk you through the essential cash-related KPIs to help you get on top of your cash management. None of this should replace the need for a cash flow forecast.
Operating Cash Flow (OCF)
Operating Cash Flow = Net Income + Non-Cash Expenses + Change In Working Capital
Let’s break down each of these elements:
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Net Income - Net profit after tax
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Non-Cash Expenses - Items on your P+L that do not involve cash moving. For example, Depreciation, Amortisation, Gains on Investments
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Change in working capital - Current Assets minus Current Liabilities
Straight away, you can see why non-finance-trained founders would struggle with putting this together, you will need help from your accountant, but you must understand what it means and why it is important.
OCF shows the cash you generate from the day-to-day operations of your core business. It excludes things like investments and loans. A strong Operating Cash Flow is at the heart of any strong business.
Cash KPIs
Cash Conversion Cycle (CCC)
CCC = Average Stockholding Days + Average Receivable Days - Average Payable Days
Monitoring how many days it takes for you to get paid, to pay your suppliers and how long you hold stock for all form part of the Cash Conversion Cycle.
I won’t go into detail here about this, as I covered it in a recent post:
Liquidity Ratios
If you are unfamiliar with the term liquidity, it means the ability to find cash to pay short-term debts. The more liquid you have, the more free cash you have or can get access to quickly.
There are three different ways to track this:
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities
Cash Ratio = Cash / Current Liabilities
All three of these essentially do the same thing. They measure your ability to cover your short-term debts (Bills, Loans under 12 months, taxes owed etc.) with your current assets (cash, stock, accounts receivable etc.).
Where they differ is how easily available the cash is. The current ratio, for example, will include Stock and other items that might be very hard to convert to cash quickly if you need to pay off a bill. At the other end, the cash ratio is what you have right now but ignores money that will soon come into the business from clients etc.
These KPIs are expressed as a ratio, showing how many times over you can cover your debts. So a ratio of 2 means you have twice the amount of cash/assets (depending on which ratio you are looking at) you need to cover short-term debts.
It is important to remember we are only looking at the ability to cover short-term debts here, so ignore any long-term loans or other debt you might have.
A ratio of 1-3 is generally considered healthy. Anything below 1 means you can’t cover your short-term debts, and you will struggle to operate at this level for long without equity or long-term funding. Anything above 3 shows you probably have more cash than you need, and it could be better invested in other areas of the business.
Free Cash Flow (FCF)
Free Cash Flow = Operating Cash Flow - Capital Expenditures
FCF goes one step further than just monitoring cash from operations. It considers the need to maintain or expand your Fixed Assets, which is necessary for your business to grow. It shows us what the business has left over to cover the debt, pay dividends, or reinvest in the business for growth.
Cash Flow Coverage Ratio (CFCR)
CFCR = Operating Cash Flow / Total Debt
Total debt includes short and long-term debt. This ratio shows us the ability of the business to cover its obligations from operations.
A ratio of 1.5 and above is considered good for most, but this will vary by industry.
Out of all the KPIs we regularly monitor, this is one of the few that factors in long-term liabilities too.
Cash Burn & Runway
Cash Burn = Cash at the start of the period - Cash at the end of the period
Measured Monthly or Quarterly, this shows us the net cash position of the business ie how much more you are spending vs what you are bringing in
Cash Runway - Current Cash balance / Cash Burn Rate
Based on how quickly you are burning cash, how many months/quarters will it last?
Both are very basic but critical cash flow measures for loss-making start-ups. They can form an essential part of the picture when it comes to deciding how much investment to raise and when.
Expense Coverage
One of the favourite cash measures for business owners is to set a target of having x months of expenses in the bank. It’s beautifully simple and gives those who might not have access to or understand the more complex combination of KPIs above the confidence to make braver growth decisions.
The number of months of coverage ranges from 3 - 12, with 6 being the most common, depending on the risk appetite of the founder.
Profit Margins
Although not strictly cash KPIs, I always want to look at the gross and net profit margins alongside the others to understand the cash position better.
Remember, cash flow and profit are very different things. You can make a profit and still struggle with cash flow; however, having positive cash flow without profit is very hard.
Using The Right KPIs
Looking over the list above might bring massive overwhelm for many founders. It’s vital that you pick and choose the right KPIs for your industry and for your business. You probably won’t need to look at every one of these every month!
Each of these KPIs tells the same overall story but from a different perspective. It’s why you can’t simply rely and fixate on one measure.
Simplicity is great. A couple of these measures are straightforward for you to get started with on your own, but as your business grows, you will quickly need to take a broader view and really understand the story these tell.
About the author
Luke Desmond
Fractional CFO for Tech, eCommerce & SaaS. CEO @Crisp_Acc provides virtual finance functions. Co-Founder @getvaulta SaaS Startup for accountants.