Maintaining a strong cash flow is essential for the overall health of a business. While cash flow can fluctuate greatly during periods of expansion or short-term projects, some techniques can be used to identify and manage short-term cash flow issues and plan for long-term growth.
Learning about cash gaps, Financial Gaps Analysis and cashflow financial ratios are great ways that can help you get started with cashflow optimisation.
Let’s learn about each analysis tool from key takeaways from the last of our 3-part Financial Wellness series in partnership with Westpac’s Davidson Institute.
Understanding cash gaps in your working capital cycle
One of the key drivers of cash flow is the working capital cycle. This cycle can vary significantly between businesses and can greatly impact cash flow. For example, cash may decrease during peak seasons when sales are rising. This can happen because of the timing of cash flows and the time it takes for dollars to go around the working capital cycle
Cash gaps: An illustration
Let’s say a business makes sales of $100. The cost of the goods sold was $80, and the business made a profit of $20. However, if the business operates on a credit system, the cash in the bank account may actually be down $40. This is because the business has invested $100 in sales and has incurred a debt of $100 but has only collected $80 from past sales. This results in a cash shortfall or “cash gap” of $20.
What about cash surpluses?
Interestingly, when sales decline at the end of a peak season, the opposite occurs, and cash surpluses may happen. For example, if a business made sales of $100, the cost of goods sold was $80, and the business made a profit of $20, the cash flow may be positive by $40.
This is because the business is collecting debtors from past sales when sales were higher and purchasing stock at a lower level for future sales.
The size of these cash gaps will depend on how quickly the business can turn the working capital cycle. The faster the cycle turns, the smaller the gaps will be.
How to manage working capital and improve cashflow in your business
Managing cash for long-term growth
The Financial Operating Cycle
To better understand how business growth impacts cash, we’re going to use a model called the financial operating cycle to help us understand how your business works financially.
The cycle begins with the owner’s equity – the money invested in the business. To keep the business running, the owner may also borrow money, which is referred to as liabilities. These funds are then used to purchase assets, such as stock and equipment, to make sales. The business earns a profit from these sales, which can be reinvested in assets, used to pay off debt, or taken out of the business.
Understanding the financial operating cycle and how it affects the balance sheet is key to optimising long-term cash flow. Additionally, an increase in sales and profits will also require an increase in assets which may need to be financed.
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The Financial Gap Analysis
When you’re business is growing, and you want to plan for long-term growth, you need to look at factors other than the cash gap. This is where the financial gap analysis will be helpful.
Financial gap analysis is about predicting your business at the same efficiency level that is continuing to generate the same profit margin, using a proportional amount of assets while growing your sales.
The Financial Gap Analysis
When you’re business is growing, and you want to plan for long-term growth, you need to look at factors other than the cash gap. This is where the financial gap analysis will be helpful.
Financial gap analysis is about predicting your business at the same efficiency level that is continuing to generate the same profit margin, using a proportional amount of assets while growing your sales.
Financial Gap Analysis: An illustration
For example, a business currently makes $10,000 in profit, with $50,000 in sales and $100,000 in assets. The business aims to double its profit the following year to $20,000. Using the same efficiency level, the business will need to make $100,000 in sales, which would require $200,000 in assets. The business will also retain the $20,000 in profits, resulting in a net worth of $120,000. However, this would still leave an $80,000 gap, which could be financed through new liabilities.
Financial Gap Analysis can be a valuable tool for rapidly growing businesses to estimate the funding they may need and optimise where that funding comes from. The analysis can indicate that businesses need to collect payments quickly and purchase stock at the right times.
Monitoring cashflow
Let’s look at the short-term and long-term impacts of cash. How do you keep an eye on your cash to ensure it’s being optimised?
A useful tool to measure cash flow performance is a set of financial ratios.
Cashflow performance ratio analysis
1. Current Ratio
This indicates your ability to pay bills on time and is calculated by dividing current assets by current liabilities. A ratio of 1 or higher is desired.
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2. Net Margin
Measures the efficiency of converting sales into profits and is calculated by dividing profit by sales.
3. Sales-to-Assets Ratio
The efficiency of using assets to generate sales is calculated by dividing sales by assets. A stable or increasing ratio is desired.
4. Stock Days Ratio
Indicates the number of days on average that stock sits on the shelf before being sold and is calculated by dividing the cost of sales by stock. A stable or decreasing ratio is desired.
5. Debtor Days Ratio
Indicates the number of days on average it takes customers to pay and is calculated by dividing credit sales by debtors. A ratio within credit terms and stable or decreasing is desired.
6. Credit Days Ratio
Indicates the number of days it takes to pay suppliers and is calculated by dividing the cost of sales by creditors. A ratio similar to the terms offered by creditors and stable is desired.
The cashflow budget
The cashflow budget is an essential tool in optimising your cash flow. A cashflow budget helps understand how cash flows through the business and forecast potential shortfalls. This budgeting tool allows the business to take appropriate action, such as collecting debts faster, negotiating better terms with suppliers, or changing the timing of purchases.
Without a forecast, the only option may be a costly and stressful temporary overdraft. Additionally, it is essential to compare actual cash flow with the forecasted cash flow each month to understand any changes and keep learning about the business’s cash flow.
Strengthen your cash flow with AR automation
Optimising your cashflow is essential to keeping your business running smoothly. By understanding the drivers of cash in the short and long term, you can make informed decisions about managing your money best to reduce gaps and optimise how cash flows in and out of your business.
AR automation software can help you manage your cashflow, so you can focus on what you do best – growing your business. Speak with one of our AR experts today to learn about options for your business.
