'Cash is king' is a phrase often used in business because cash is the item that keeps a business 'alive.' Even an otherwise profitable business cannot continue without cash and may be forced to liquidate or go into bankruptcy. In the current economic climate of credit squeeze, cash is an even hotter commodity.
Cash flow is an issue every small business grapples with on a daily basis. Much more than any other single factor, cash flow problems exist and increase over time because the business owner is not in control of the finances of the business. Making sure that the books and accounts are properly kept and up to date is one thing, knowing how to determine indicators of cash flow position from the books is another; this will be the focus of this discussion.
Statement of Cash Flow
Many assume that cash flow is revenue from sales; nothing is further from the truth. The 'Statement of Cash Flows', tracts the cash flows into and out of the business and is the Financial Statement that shows the cash position. The first section of the Cash flow Statement shows 'Cash from operating activities,’ a positive cash flow from operating activities is the amount of cash generated by a business's profit making operations. This is an indication of the ability of the business to turn profit into cash which can be used to meet the cash needs of the business. A business may experience growth as indicated by increase in accounts receivable and payable and inventory, and other assets but this growth can be easily jeopardized by deterioration in cash position as would be indicated by the cash flow decrease.
Liquidity
This is another important indicator of a business' cash flow position. It is simply the ability of an asset to be converted into cash quickly and without any price discount. Again using the financial information, the business owner or his/her Accountant can calculate a set of liquidity ratios to indicate the cash health of the business.
Liquidity ratios are a class of financial metrics that are used to determine a company's ability to pay off its short-terms debt obligations; generally the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts. The most common of these is the current ratio and the quick ratio.
The current ratios is Current Assets divided by Current liabilities and the Quick ratio is
Quick assets (Cash + Account Receivable and Short term investments) divided by Current liabilities.
A general rule of thumb (this will differ for diverse industry and business types) is between 1.2 & 2.0 for current ratio and 1 for quick ratio. Ratios below the accepted average generally mean that the current debt obligations exceed the amount of money available to pay those debts. That obviously means the business is headed for cash flow problems.
Another important indicator of liquidity is the debt coverage ratio. This is
Earnings before interest, taxes, depreciation and amortization EBITDA divided by the interest expense.
This answers the questions 'does the company generate enough profits to pay interest obligations?' Default in interest payment compromises ability to receive additional credit or may even mean the termination of current credit facilities which may already be the life wire of the business.
Cash generated from Sales
Sales are the primary way a company generates cash. The cash return on sales is the indicator used here and is calculated by
Net Cash provided by operating activities divided by Net Sales
Additionally this ratio may be compared with the profit margin, if lower, then this is a sign of strain on cash flow.
Cash flow Coverage
A business needs to fund future growth and expansion, as well as pay its current obligations of the daily running of the business, debts and interest. A growing business is attractive to the investing public and sources of credit. A non healthy cash flow coverage, though not an indicator of immediate cash crises may affect a company's ability to raise cash in future. It is calculated by
Cash provided by operating activities' divided by cash requirements (Capital expenditure, cash dividends, interest, current portion of long term debt)
The reader should keep in mind that there are also non-financial indicators of cash availability, these are not the primary focus of this write-up but would include; Poor relationship with current bankers, percentage of market share, new profits growth, average dollar sales per transaction, number of transactions per unit time, what factors generate sales, customer satisfaction, number of customers, ratio of new to existing customers and customer retention ratio.
