A company may be profitable but have poor cashflow.
Here are 5 KPIs to measure and improve working capital and cashflow.
5 Best KPIs for Working Capital
1.Days Sales Outstanding
Days Sales Outstanding (DSO), also called Debtors Days, measures how long it takes your customers to pay you.
We measure this by dividing accounts receivable by average daily sales.
Example:
Sales are $300 000 per month = $10 000 per day in a 30 day month.
Accounts receivable is $450 000.
450 000/ 10 000 = 45 days.
We want to keep this number at or below our target. We set the target based on our average expected payment terms.
Example:
Terms are 30 days from end of month.
A customer invoiced on 1 March will pay on 30 April = 60 days.
A customer invoiced on 31 March will pay on 30 April = 30 days.
On average we will be paid in 45 days (60 + 30 ) / 2 = 45
Our target for DSO is 45 days
To improve DSO and cashflow:
Vet customer credit well at the outset. Customers with poor credit records are likely to be bad/slow payers.
speed up invoicing - the faster we invoice, the faster we will collect cash
tighten up on collections - automated invoice reminders, follow-up emails and phone calls
offer settlement discounts to customers who pay early.
2.Days Payables Outstanding
On the other side of sales is purchases.
We need to pay suppliers on time to remain on good terms. However, we should extend payment terms if we can; this will extend our cashflow.
The calculation is similar to the calculation for days sale outstanding. e.g. if our payment terms are 30 days, we will also have average measurement of 45 days.
We want to be within a reasonable range of our terms.
To improve cashflow, we should:
manage purchases carefully; time the arrival of inventory to sales cycles.
extend payment terms if possible
control purchases against budgets.
3.Days Inventory Outsanding
For retail and wholesale businesses, inventory is usually the biggest cash investment.
The faster we can get inventory sold, the better our cash cycle becomes.
Toolbox to imporve:
match purchase volumes with expected sales
identify slow moving items and use sales promotions to move the inventory faster
optimize distribution - the faster inventory is delivered, the better our cash flow
4.Current Ratio
The current ratio (ratio of current assets to current liabilities) is a quick measure to see if your receivables, cash and inventory are high enough for you to pay your suppliers.
Receivables will take time to turn into cash - maybe 30 - 60 days.
Inventory will take even longer - maybe 3 months before the average item is sold.
On the other side, your suppliers want to be paid in the next 30 - 60 days.
Keeping the ratio of cash + receivables + inventory far above your payables gives you a safety net.
The most common guideline is 2 : 1
5.Working Capital
Another way of measuring your cashflow health is the working capital.
Take your operating costs (employees, occupancy, administration etc.) and work out the monthly average
Decide on the buffer needed - 3-4 months is a good guide.
Your working capital should equal or exceed the buffer.
Example
Operating costs (rent, utilities, employee costs, accounting and administration etc.) are $200 000 per month.
Our working capital should be at least 3 months x 200 000 = $600 000.
