What directors need to know about cashflow: metrics and red flags

For board directors, maintaining a firm grasp on the financial health of their organisation is a core responsibility, and central to this is the management of cashflow.

Cashflow, often referred to as the lifeblood of a business, provides critical insights into a company's liquidity, operational efficiency, and overall financial stability. Unlike profit, which is an accounting measure, cashflow reflects the actual liquidity available to meet the company's obligations, invest in growth, and sustain long-term operations. In this context, understanding key cashflow metrics—such as operating cashflow margin, free cashflow, and the cash conversion cycle—becomes indispensable for directors who are tasked with making informed strategic decisions. These metrics help assess the company's ability to generate cash and play a crucial role in identifying potential risks that could impact the company's financial health and stability. 

This is the second of a series of three articles exploring directors and their cashflow responsibilities within an organisation. The first article is What directors need to know about cashflow: an overview.

Cashflow metrics

Operating cashflow margin

The operating cashflow margin measures the percentage of cash generated from operating activities relative to total revenue. This metric is a key indicator of a company's ability to generate cash from its core business operations and maintain operational efficiency.

Operating Cashflow Margin = (Operating Cashflow ÷ Total Revenue) x 100

For example, if a company has an operating cashflow of $500,000 and total revenue of $2,000,000, the operating cashflow margin would be:

(500,000 ÷ 2,000,000) x 100 = 25%

Significance:
A higher operating cashflow margin indicates that a company is efficiently converting its revenue into cash, which is crucial for covering operating expenses, investing in growth, and managing debt. Conversely, a low or declining operating cashflow margin may signal operational inefficiencies or issues with revenue collection, necessitating further investigation by the board. 

Free cashflow

Free cashflow (FCF) represents the cash generated by a company after accounting for capital expenditures required to maintain or expand its asset base. FCF is a critical measure of a company's financial flexibility and ability to pursue strategic initiatives such as acquisitions, debt reduction, or dividend payments.

Calculation:
For instance, if a company has an operating cashflow of $700,000 and capital expenditures of $200,000, the free cashflow would be:

700,000 - 200,000 = 500,000

Significance:
Positive free cashflow indicates that a company generates enough cash to cover its capital investments and still has surplus funds for other purposes. Persistent negative free cashflow, on the other hand, may indicate that the company is not generating sufficient cash to support its growth initiatives or meet its financial obligations, which could raise red flags for board directors. 

Cash Conversion Cycle

The cash conversion cycle (CCC) measures the time it takes for a company to convert its investments in inventory and other resources into cash from sales. The CCC is a crucial metric for assessing a company's operational efficiency and liquidity management.

Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding

1. Days Inventory Outstanding (DIO): The average number of days it takes to sell inventory.
2. Days Sales Outstanding (DSO): The average number of days it takes to collect payment from customers after a sale.
3. Days Payable Outstanding (DPO): The average number of days it takes to pay suppliers after receiving inventory.

Significance:
A shorter cash conversion cycle indicates that a company can quickly convert its investments into cash, enhancing liquidity and reducing the need for external financing. A longer CCC may signal inefficiencies in inventory management, sales collection, or payment processes, prompting board directors to investigate further.

Liquidity ratios

Liquidity ratios measure a company’s ability to meet its short-term obligations using its current assets. The two primary liquidity ratios are the current ratio and the quick ratio.

Current ratio

The current ratio compares a company's current assets to its current liabilities, providing a snapshot of its short-term financial health.

Current Ratio = Current Assets ÷ Current Liabilities

For example, if a company has current assets of $1,000,000 and current liabilities of $600,000, the current ratio would be:

1,000,000 ÷ 600,000 = 1.67

A current ratio above 1 indicates that the company has more current assets than current liabilities, suggesting good short-term financial health. However, an excessively high current ratio may indicate inefficient use of assets. A ratio below 1 could signal liquidity issues, which should concern board directors.

Quick ratio

The quick ratio, also known as the acid-test ratio, measures a company's ability to meet its short-term obligations without relying on the sale of inventory. It excludes inventory from current assets to provide a more stringent assessment of liquidity.

Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities ​

For instance, if a company has current assets of $1,000,000, inventory of $400,000, and current liabilities of $600,000, the quick ratio would be:

(1,000,000 − 400,000) ÷ 600,000 = 1.0

A quick ratio above 1 suggests that the company can meet its short-term obligations without relying on the sale of inventory, indicating strong liquidity. A ratio below 1 may raise concerns about the company’s ability to cover its immediate liabilities, prompting further review by the board.

Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) measures a company's ability to service its debt using its operating income. It is a key metric for assessing the company's financial stability and risk of default.

Calculation:
Debt Service Coverage Ratio = Net Operating Income ÷ Total Debt Service

For example, if a company has a net operating income of $800,000 and total debt service (principal and interest payments) of $500,000, the DSCR would be:

800,000 ÷ 500,000 = 1.6

Significance:
A DSCR above 1 indicates that the company generates enough operating income to cover its debt payments, suggesting good financial health and lower risk of default. A DSCR below 1 may indicate that the company is struggling to meet its debt obligations, raising red flags for board directors and potentially requiring action to improve cashflow or reduce debt. 

Days Sales Outstanding (DSO)

Days sales outstanding (DSO) measures the average number of days it takes for a company to collect payment from its customers after a sale. It is a critical metric for assessing the efficiency of the company’s credit and collections processes.

Calculation:
Days Sales Outstanding = (Accounts Receivable ÷ Total Credit Sales) × Number of Days

For example, if a company has accounts receivable of $600,000 and total credit sales of $3,000,000 over a 90-day period, the DSO would be:

(600,000 ÷ 3,000,000) × 90 = 18 days

Significance:
A lower DSO indicates that the company is collecting payments from customers quickly, which enhances cashflow and reduces the risk of bad debts. A higher DSO suggests that customers are taking longer to pay, which can strain cashflow and may indicate issues with the company’s credit policies or collections processes. Board directors should monitor DSO trends and take corrective actions if necessary.

Days Payable Outstanding (DPO)

Days payable outstanding (DPO) measures the average number of days it takes for a company to pay its suppliers after receiving goods or services. It is a key metric for assessing the efficiency of the company's payables management.

Calculation:
Days Payable Outstanding = (Accounts Payable ÷ Cost of Goods Sold) x Number of Days)

For example, if a company has accounts payable of $400,000 and a cost of goods sold of $2,000,000 over a 90-day period, the DPO would be:

(400,000 ÷ 2,000,000) x =18 days

Significance:
A higher DPO indicates that the company is taking longer to pay its suppliers, which can improve cashflow but may strain supplier relationships. A lower DPO suggests that the company is paying its suppliers quickly, which can enhance supplier relations but may reduce cash reserves. Board directors should ensure that the company's payment terms are balanced to optimise cashflow while maintaining good supplier relationships.

The ability of a company to effectively manage its cashflow is a critical determinant of its success. For board directors, this means going beyond merely reviewing financial statements to understanding the intricate details of how cash moves through the business. Metrics like operating cashflow margin, free cashflow, and the cash conversion cycle offer valuable insights into a company's efficiency, liquidity, and financial flexibility. By closely monitoring these indicators, directors can ensure that the company is well-positioned to meet its obligations, invest in growth, and navigate financial challenges. Ultimately, sound cashflow management is not just about preserving liquidity but about safeguarding the company's future and fulfilling the fiduciary duty to act in the best interests of shareholders.