Managing
Cash Flow
Knowing how to measure
cash flow is just one of the skills you need to manage the cash flow
of your business. The statement of cash flow shows you where your
cash comes from, where you spend it, and the net change in cash for
the year. Understanding how the cash "flows" through your business
can help you to forecast and manage your business. To manage cash
flow effectively, you must follow the operating cycle of your business
and see how to use the operating cycle to forecast cash flow in the
future.
Operating Cycle
The operating cycle measures
the length of time that it takes a business to convert cash outflows
for raw materials, labor, etc., into cash inflows. This cycle will
determine, to a large extent, the amount of capital necessary to start
and operate your business. The operating cycle consists of three sub-cycles:
- Accounts receivable
cycle
- Inventory cycle
- Accounts payable cycle
Accounts Receivable
Cycle
The accounts receivable
cycle measures the length of time it takes a business to convert a
sale into cash. In other words, how long does it take a business to
collect its accounts receivable.
The following diagram depicts
the cycle:
Sale -> Accounts
Receivable -> Cash
One way to measure the
length of time it takes to convert a sale into cash is by calculating
the number of days of cash receipts invested in accounts receivable.
The calculation consists
of two steps:
|
1. Calculate
average daily sales:
|
|
Average daily sales
=
|
Annual Sales
------------------
360*
|
|
2. Calculate
average daily sales in accounts receivable:
|
|
Average days of
sales in accounts receivable =
|
Accounts receivable
-----------------------
Average daily sales
|
*Accepted
accounting practice calculate the number of days in a year at 360
(30 per month x 12 months). This is the common figure to use when
calculating daily averages based on annual figures.
Using information from
Best Company (accrual basis), you know that the total sales for the
company is $1200 ($400 cash sales + $800 sales on account). So the
average daily sales is calculated:
$1200
----------
360
|
= $3.3 daily sales
|
You also know that accounts
receivable at the end of the year was $200 ($800 sales on account
&endash; $600 collections on accounts). So the average daily sales
in accounts receivable is calculated:
$200
----------
$3.3
|
= 60 days
|
Inventory Cycle
The inventory cycle measures
the length of time it takes your business to convert inventory into
cost of sales. This represents the number of days of cash invested
in inventory.
The following diagram depicts
the cycle:
Cash -> Inventory
-> Cost of Sales
One way to measure the
length of time it takes to convert inventory into cost of sales is
by calculating the average number of days of cost of sales in inventory.
The calculations consist
of two steps:
|
1. Calculate
average daily sales:
|
|
Average daily sales
=
|
Annual Sales
------------------
360*
|
|
2. Calculate
average daily sales in accounts receivable:
|
|
Average daily cost
of sales in inventory =
|
Inventory
-----------------------
Average daily cost of sales
|
Using information from
Best Company (and assuming cost of sales is 60% of sales), the average
cost of sales per day is calculated:
$720
----------
360
|
= $2.0 daily cost
of sales
|
The average daily cost
of sales in inventory (assuming inventory is $200) is calculated:
$200
----------
$2.00
|
= 100 days
|
Accounts Payable Cycle
The accounts payable cycle
measures the length of time it takes your business to pay its accounts
payable. It represents the number of days of cash financed by your
creditors. The following diagram depicts the cycle:
Cash -> Accounts
Payable
One way to measure the
length of time it takes a business to pay its accounts payable is
by calculating the average number of days of cost of sales in accounts
payable.
The calculations consist
of two steps:
|
1. Calculate
average daily cost of sales:
|
|
Average daily cost
of sales =
|
Cost of Sales
------------------
360*
|
|
2. Calculate
average daily sales in accounts receivable:
|
|
Average daily cost
of sales in accounts payable =
|
Accounts payable
-----------------------
Average daily cost of sales
|
Again, using the Best Company
as an example and assuming the average daily cost of sales is $2.00,
the average daily cost of sales in accounts payable is calculated:
$100
----------
$2.00
|
= 50 days
|
The operating cycle is
the sum of the sales and inventory cycles less the accounts payable
cycle. It represents the length of time from when a business purchases
materials and other costs of production to make a product until the
time the business collects the accounts receivable from the sale of
the product, reduced by the financing of the costs of production by
the business's vendors.
The cash cycle for the
Best Company is calculated:
|
|
Days
|
|
Accounts receivable
cycle
|
60
|
|
Inventory cycle
|
100
|
|
Accounts payable
cycle
|
(50)
|
|
Operating cycle
|
110
|
The business has 160 days
of sales invested in its accounts receivable and inventory. If vendors
are financing 50 days of sales, owners of the business must finance
the remaining 110 days with capital, either loans or equity.
The operating cycle is
dependent on a number of factors including the business's credit and
collection policies, the business's inventory management policies,
and the business's credit rating and payment patterns. The business
can shorten it's operating cycle by implementing or strengthening
the policies and procedures in these areas.
Forecasting Cash Flow
An accurate cash flow forecast
requires an understanding of the financial statements of the business
and a good sense of how different accounts relate to one another.
For instance, you should know how accounts receivable are correlating
with sales, or how expenses correlate with accounts payable.
Using the Best Company
as an example, we can prepare an simplified cash flow forecast using
the following assumptions in developing a cash flow forecast:
|
Assumptions:
|
|
|
Sales
|
10% growth
|
|
Cost of sales
|
60% of sales
|
|
Fixed expenses
|
$250
|
|
Depreciation expense
|
$150
|
|
Interest income
|
$100
|
|
Proceeds on equipment
sales
|
$-0-
|
|
Equipment purchases
|
$500
|
|
Tax rate
|
40%
|
|
All other accounts
|
Expected to remain
the same as in year 1
|
The forecasted income statement
of the Best Company is expected to be as follows:
|
Sales
|
$1320
|
|
Cost of sales
|
528
______
|
|
Gross profit
|
660
|
|
|
|
|
Operating expenses
|
150
|
|
Depreciation
|
150
______
|
|
Total expenses
|
300
|
|
|
|
|
Operating income
|
360
|
|
Interest income
|
100
|
|
Income before taxes
|
460
|
|
Income taxes
|
184
______
|
|
Net income
|
$276
|
Cash Flow Statement (Indirect
method):
|
Operating Activities:
|
|
|
Net income
|
$276
|
|
Add: non-cash items
depreciation
|
150
|
|
Changes in current assets and liabilities
|
|
|
Accounts receivable
|
(20)
|
|
Inventory
|
(20)
|
|
Accounts payable
|
10
|
|
Cash received from
operations
|
396
|
|
Investing Activities:
|
|
|
Equipment purchases
|
500
________
|
|
Net change in cash
before financing activities
|
$(104)
|
In this example, Best Company
knows that it must arrange financing of $104 o cover cash shortage
for next year's forecasted operations. The cash flow forecast allows
the business to plan ahead and anticipate cash flow shortages.
Most forecasts are based
on a business's financial history. They can be projected from a month's,
a quarter's or a year's worth of financial records. If you are just
beginning your business, you can still do worthwhile projections.
Certain industry standards exist for many businesses from which to
do projections. Consult RMA Annual State Studies (Robert Morris Associates:
Philadelphia, Penn.) or Almanac of Business and Industrial Ratios
(Leo Troy, PhD, Prentice Hall: Englewood Cliffs, N.J.)
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