When reviewing your financial data each month, there are many key figures to take into consideration. How do you analyse the numbers to determine the most important factors? It’s often said that revenue is vanity, profit is sanity, but cash is reality. Because cash flow is so crucial to business success, focusing on what drives your business’s cash flow is an excellent start.

There are seven key financial drivers of cash flow. Each driver provides valuable information that, when taken together, will help you identify the areas you need to improve for positive cash flow and strategic business decisions.

The three drivers of the balance sheet are:

Debtor days
Stock / Work in Progress days
Creditor days

The four drivers of profit are:

Price
Volume
Cost of Goods Sold
Overheads

1. Debtor Days Ratio

Your debtor days ratio shows the number of days (on average) cash is being collected from customers.

Debtor Days	= Debtors / Average daily sales
	= Debtors / (Annual sales / 365)

If you are using sales for a different period (eg. monthly) then replace the 365 with the number of days in the period.

Reducing debtor days through sound debtor management will improve your cash flow. Remember that a good customer is one that pays so ensure you have a solid credit policy and an efficient debtor collection process in place. If your business isn’t collecting cash quickly, then you are funding the customer’s business as well as your own.

2. Stock Days Ratio

Your stock days ratio shows the number of days (on average) your business holds its stock before selling it (ie. the number of days your cash is tied up in stock).

Stock Days

= Average stock / (Cost of goods sold / 365)

If you are using sales for a different period then replace the 365 with the number of days in the period.

For product-based businesses, stock days is a measure of the efficiency of stock control in the business. If your stock days are increasing it indicates that your business is building up stock and an increasing amount of cash is tied up. Downward trends in the stock days ratio indicates that stock levels are being kept under control in relation to the level of sales. However, when a stock days ratio falls too low it may result in supply shortages as demand fluctuates.

For manufacturing-based businesses, you can also use this formula if you put a dollar figure on your Work In Progress (WIP). Your WIP days are the days between when wages and materials are paid for and when the job is completed and invoiced. Streamlining the job management process will reduce the number of WIP days, and have a positive effect on cash flow.

For service-based businesses, WIP is used as a measure between when the client order begins until when the job is invoiced. Monitoring WIP days in service businesses is just as important as the effect on working capital is the same as in product or manufacturing industries.

3. Creditor Days Ratio

Your creditor days ratio shows the number of days (on average) your business takes to pay suppliers.

Creditor Days	= Creditors / Average daily purchases
	= Creditors / (Annual purchases / 365)

If you are using sales for a different period (eg. monthly) then replace the 365 with the number of days in the period.

If Creditor Days are increasing beyond your supplier’s trading terms it indicates that your business is not paying as efficiently as it should be and this may lead to supply problems. Downward trends in the Creditor Days ratio may indicate that there are reduced cash reserves in your business, which can affect growth and expansion plans.

4. Price Change %

Price change percentage refers to the percentage increase or decrease at which you can sell your products or services. Your business needs to be able to accommodate variations in the market so it’s important to know your margins and know how much room you have to move. In highly competitive markets it may be tempting to sell for the lowest price possible, however, if you see your profit margins dwindling it might be time to re-evaluate your pricing. Discounting some products or services in order to gain business for other more profitable ones is a better tactic.

5. Revenue Growth

It may seem logical that selling more products or services will improve cash flow, however, increasing sales can actually add to cash flow problems. Sales require a cash outlay. You need to pay for the materials, buy the products or pay for the labour to deliver your product long before you receive any payment. For service-based businesses, an increase in sales will mean increasing the number of hours required to complete the additional work. Many business owners focus a lot of attention on increasing revenue by making more sales, and this is obviously critical to the growth of a business. For cash flow purposes though, it is more critical to know what those sales cost you to make, and what they cost you to fund. Because so many other factors contribute to profitability, it’s important to manage your other numbers well to avoid a cash flow crisis.

6. Cost of Goods Sold (COGS)

Your COGS are essentially all of the costs that are directly associated with producing a product or delivering a service. They are also referred to as direct costs or variable costs. COGS vary depending on your business’s production volume – rising as production increases and falling as production decreases. Variable costs differ from overheads (or indirect costs) such as rent, advertising, insurance and office supplies, which tend to remain stable regardless of production output. Reducing COGS has a direct impact on your bottom line by increasing gross and net profit. Steps to reduce your COGS can include buying in bulk, negotiating with your suppliers for better rates, and reducing waste. If you are a service-based business, attention to efficient work practices and job management will have the same effect. Knowing how many labour hours you are selling, compared to how many you are paying for, will provide an opportunity to manage differences and tighten up your processes.

7. Overheads %

Indirect expenses, that are not directly related to producing goods or services, are termed overhead costs. Overhead costs are typically expressed as a percentage of sales. Keeping the proportion of overhead costs low will improve cash flow as well as give your business a competitive advantage – either by increasing profit margins or by allowing for competitive pricing.

Overheads %

= Overheads / Revenue

Summing Up

The key to successful cash management is to monitor all the elements of the working capital cycle. The faster the cycle turns, the faster your trading activity converts into available cash. Introducing relatively small changes to your financial management practices can result in significant improvements to cash flow and reduced reliance on banks and suppliers for cash.

Further help:

Read our article on calculating your break-even point

Find out about using Cash Flow Story to monitor the key cash flow drivers of your business.

If you’d like to discuss your business cash flow concerns with one our business improvement advisors, please contact us on 07 3023 4800 or at mail@marshpartners.com.au

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