We discussed in the previous blog posts that when determining how healthy a business is, there are several factors to take into account. We also discussed how situations vary from one business to another, and that context matters when evaluating the true meaning of a number such as cash flow. In addition, business owners and accountants often seem to be speaking a different language between bank statements, balance sheets, and profit and loss reports, further complicating the attempt to evaluate the health of the business.
We know that a measure of the success of a business is consistent positive cash flow. But did you know there are seven ways to increase positive cash flow?
These seven cash flow drivers are:
Increase Profit
It may sound obvious, but the primary way for a healthy business to see consistent positive cash flow is to increase its profits. You might be surprised to hear, however, that profits don’t automatically equal positive cash flow. It’s only about half the picture of what’s happening with a business’s funds. But if the business maintains consistent or increasing profits, it is likely the company is heading in the right direction.
The rest of the drivers listed all affect the Net Profit of the business.
Decrease Accounts Receivable Balance
This one might sound counterintuitive. After all, if you have a lower Accounts Receivable Balance on the books, doesn’t that mean there is less money coming into the business?
What you really want to look at is the Days Sales Outstanding (DSO) number. If the business has an Accounts Receivable Balance of $50,000, but the DSO is 45, then the money owed for sales or services likely won’t be collected in the current month. This lowers the potential cash flow for that month while the AR Balance remains high. By shortening the DSO, the AR Balance will be brought in the same month a sale occurred. Money coming in lowers the A/R Balance but increases cash flow.
Decrease Inventory Balance
Again, this one seems obvious and is closely tied to profit. After all, if your inventory decreases, your A/R increases and your profit increases. The number you want to look at here is Days Inventory Outstanding (DIO). You want your turnover of goods to be as low as prudently possible without running out of inventory. Quick turnover means sales are coming in and products are going out. Not running out of inventory assures successful future sales that can be processed without significant delays.
Sale of Other Assets
This is cash coming in for the month (or quarter) that is not tied to inventory or services. However, this is not or should not become, a consistent means of income. It is useful during a cash flow crunch to help mitigate negative cash flow. It also helps offset the cost of new assets. So, while it is a way to bring cash in and increase cash flow, it is not a sustainable method for a healthy business.
Increase Accounts Payable
This is another category that seems, on the surface, to be counterintuitive. After all, the more you owe, the more you have to pay which is money going out and decreasing your cash flow. However, think of this as the opposite of Accounts Receivables. And like A/R, the number to look at is Days Payables Outstanding (DPO). Company A is a reliable customer to its vendor. As a result, the vendor extended to it a 30-days same as cash offer. Company A is able to buy inventory and hold off paying its vendor for 60 days. The cash for purchases did not leave the company for over 30 days, therefore there was no cash flowing out for A/P, increasing the overall cash flow for that month. Increasing DPO increases cash flow.
Add to Debt
Adding to the debt of the company increases the cash flow in a given month or reporting period. Like the sale of assets, this is a short-term effect. Increasing the amount of debt in one month increases the outgoing (negative) cash flow in future months. But for the month in which the new debt is added to the books, there is an increase in liquid assets and cash flow. Things happen, but as a rule, a healthy company will only increase debt to add assets that will have a positive Return on Investment (ROI).
Investments by Owner
An investment by the owner of a business is the final way that cash comes into a business, thus increasing cash flow. Again, for a healthy business, this is done for the benefit of the future of the company and should not be considered a regular means of increasing cash flow.
A healthy company is one with sustained positive cash flow. Each of these seven drivers is a means of increasing the cash flow of a company in a specific month or reporting period. Each driver is useful when used properly, though a few can also be indicators of a problem for the business. It is helpful to examine each in light of where your business is in its lifecycle, and what your goals are for the future of your business to make sure you’re on track for success.
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