Thriving in Any Economy: The Importance of Cash Flow

Thriving in any economy requires a focus on business essentials, and perhaps nothing is more essential than cash flow. 

Sufficient cash is the single most critical factor in any business. Even a growing business with high demand for its products or services can go out of business if it runs out of cash. According to research by U.S. Bank, 82% of small businesses fail due to poor cash flow management. 

Managing cash involves collecting and managing cash flows from the operating, investing, and financing activities of a company. Being able to effectively manage cash flow is not only an essential element of managing a business, but it is especially critical during economic slowdowns. 

Common Problems in Cash Flow Management

  1. Owners and/or operators don’t understand their cash flow cycle, also known as cash conversion cycle (CCC). 

    The CCC deals with the timing of the cash inflows and outflows of the business. To determine your CCC, use the following formula: Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO).

    DIO is Average or Ending Inventory divided by COGS X 365 days 
    DSO is Average or Ending Accounts Receivable divided by Revenue X 365 Days 
    DPO is Average or ending Accounts Payable divided by COGS X 365 days 

  2. Owners and/or operators don’t understand the difference between profit and cash. A company can be generating great profit and still be burning through cash. Managers need to learn to read the story contained in their balance sheets.

    To know what your free cash flow is, look to EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization (plus/minus the decrease/increase in working capital minus capital expenditure). Working capital is Accounts Receivable plus Inventory minus Accounts Payable. If the change in Working Capital is positive (an increase) then you have used cash and that amount must be subtracted from EBITDA. If the change is negative, then the business has generated cash, so the change is added to EBITDA. 

  3. Owners and/or operators lack cash management skills. 

    Cash management skills include the ability to optimize and manage working capital such as putting in the proper systems/process for collecting receivables on time, maintaining appropriate inventory levels, and making sure that payables are not paid more quickly than they need to be paid.

How to Improve Your Cash Flow

These seven elements are the drivers to higher profitability and, more importantly, to higher cash flow. 

1. Price increases
2. Sales volume increases
3. Reduction in cost of goods (COGS)
4. Reduction in operating expenses (overhead)
Even a 1% change dramatically
impacts profit & cash flow 
5. Reduction in accounts receivable (DSO)
6. Reduction in inventory (DIO)
7. Increase in accounts payable (DPO)
A change of one day can
dramatically impact cash flow

As a case study, let’s look at the recent results of a company we’ll call Pearl Industries. The 1% and 1-day changes would have generated the following results in profit and cash flow. 

The numbers show slight changes delivered improved cash flow and profit for businesses. In a recession or economic downturn, cashflow is the lifeblood that will keep your business in motion. Even minor changes can dramatically improve cashflow, and every bit counts for companies looking to thrive in any economy. 

To help your company learn more about managing cash flow, consider Business Essential Training or contact iMpact Utah for help.