David Van Damme

In light of COVID-19, business owners, CFOs and operations managers are spending a lot of time thinking about cash flow. Now, more than ever, cash is king and understanding how to plan over the next few months and beyond is vital.  Senior Manager Dave Van Damme discusses the concept of cash flow and how business owners can use this to understand profitability, with practical examples.

Video Transcription

Thanks for joining Clayton McKervey in a conversation on how to best analyze a company’s financial health. Clayton McKervey is a full service CPA firm focused on helping closely held growth-driven businesses compete in a global marketplace.

Today we will discuss some specific KPIs or key performance indicators that can help you track and measure company performance.

To learn more, check out the videos throughout the series.

So far in this series, we’ve touched on a number of levers that can be pulled as a result of assessing profitability figures. Today we’re going to switch to one that has to do with liquidity or the flexibility your business has to continue covering costs in an unforeseen event or an intentional event where the cash inflow dries up or changes significantly for a short period of time.

Specifically, we’re going to evaluate a ratio called days cash on hand, which evaluates daily cash flow for operating expenses. To get started, let’s look at an example. Today our custom machine builder is sitting on a cash balance of $900,000, and our machine builder has annual expenses of payroll, rent, utilities, office supplies, auto, et cetera, that total $3.65 million.

So, with the $3.6 million in total operating expenses, our average daily cash outflow would average about $10,000. So, circling back to our on-hand cash balance of $900,000 and $10,000 of average daily cash flow, the machine builder would be able to continue operating for 90 days with today’s cash.

So how is that computed? I took my cash on hand, divided it by my operating cash flow on a daily basis.

Why is days cash on hand important to understand other than the obvious that we don’t want to run out of cash? Well, it’s crucial to consider when, for example, evaluating a new customer contract that doesn’t provide an upfront deposit or when considering your ability to afford a new piece of equipment and determination of whether external financing may be needed or also your evaluation of whether to hire employees and increase your overhead.

So, let’s expand on this analysis by adding a competitor into the mix from the situation that we’re just reviewing. So, let’s say the second machine builder has operating expenses of $2.6 million, resulting in an average daily cash spend of about $7,100, and they’ve got a cash balance of $2 million.

So that would equate to about 280 days’ worth of cash that they have on hand. So comparatively, this would indicate that the competitor has about three times as much cash on hand to continue operating as our first company. That’s clearly more ideal, right? While this sounds like a good thing, it isn’t necessarily.

Yes, one could say that the competitor would simply last longer if something happened. However, it doesn’t mean that cash is being utilized in the most effective way.

The company with 90 days of cash on hand may have less cash because they’re investing in areas that are generating higher returns than simply if the cash were to just sit idle. Particularly interesting could be pulling in the industry standard data to say what that average is as we identify here what if for example the industry average is 120 days’ worth of cash on hand.

Could that indicate that our second entity that had close to 280 days of cash on hand is not properly reinvesting in their business to remain competitive and relevant? What other levers could be adjusted? Well, depending on the industry year-end, it could take a long time for you to potentially collect cash.

So maybe you need to evaluate renegotiating payment terms with customers and optimize the invoicing process to increase your days cash on hand.

Second, increasing sales with normal margins will of course also bring more cash into the organization and increase your days cash on hand.

The third lever to evaluate is how days cash on hand is tied directly to operating expenses. So, we need to be able to make sure that we track operating expenses closely in each area of the business and find ways to trim back if we’re looking to increase our days cash on hand.

To summarize, days cash on hand allows you to understand an important leverage indicator of your business and, on average, the number of days that an organization can continue to pay its operating expenses provided the amount of cash currently available.

Let us know your thoughts and thanks for watching.

If you are interested in learning how data analytics can help your business, Clayton & McKervey can help. For additional information call us at 248-208-8860 or click here to contact us. We look forward to speaking with you soon.

This content was also published on the Control System Integrator Association website.