Operating cash flow
Operating cash flow is the comings and goings of cash related to your core business.
This would take into account:
- operating income
- accounts receivable
- accounts payable
- accrued expenses
- depreciation on equipment used to earn this income.
Why it’s useful
Operating cash flow is useful because it shows if you are earning enough to cover your operating costs, your employees’ wages, and pay any lenders or investors.
Calculation
Your operating cash flow is calculated for you in our workbook below.
Results
Positive operating cash flow shows your business can cover its costs. The next step is to check your ability to turn any extra cash into profit. Negative operating cash flow means your earnings can only pay for a portion of your operating costs. This means you’re making no profits and you must find other ways to cover costs.
How to improve
To improve your cash flow:
- improve your invoicing process if customers don’t pay you on time
- set shorter due dates for customers, and longer terms of trade with suppliers and creditors, so you can pay your suppliers once customers have paid you
- track all costs for each job or sale, so you can be on top of your budget
- reduce your operating costs
- improve your sales – reconsider marketing, costs and pricing.
Gross profit margin and contribution margin
Gross profit margin is for your business as a whole and shows if it earns enough to cover all expenses and make money.
Contribution margin breaks this down for a specific income stream, for example a popular product line. It shows if it earns enough to cover its variable costs and contribute to fixed costs.
Why it’s useful
Both are useful because they show how much you spend to make your products or services.
As contribution margin breaks this down for each product line, service or location, you can use it to see which are worth extra effort.
A product or service doesn’t have to earn a huge profit to make a difference. If it can cover its own costs, and help pay your operating expenses, it is earning its keep.
Calculation
Both gross profit margin and contribution margin are typically shown as a percentage.
For gross profit margin, you can set up an equation using line items in your income statement.
For contribution margin, make sure your income statement separates fixed costs and variable costs for the products, services or locations you want to analyse. Then set up an equation in your accounting software or spreadsheet, or get your financial advisor to work it out.
Results
For both gross profit margin and contribution margin, a positive percentage shows earnings are enough to cover cost of goods sold and contribute to operating costs.
A negative percentage means costs outweigh earnings.
For gross profit margin, check the average (or benchmark) for your industry. Ask your accountant or advisor about data to compare your business with others like it.
How to improve
Ways to boost your margins include:
- raising prices, if customers are willing to pay more
- cutting costs.
Debt to assets ratio and current ratio
Debt to assets ratio looks at all your business’s debts (also called its liabilities) and all its assets.
Current ratio, also called working capital ratio, shows if your business can pay off its short-term debts using its short-term assets. It’s to do with paying off your debts due within a year.
These are called current liabilities on your balance sheet and include:
- rent or mortgage payments
- money owed to suppliers
- short-term loans and credit cards
- holiday pay
- income tax.
Why it’s useful
Debt to assets ratio is useful because it shows how robust, or vulnerable, your business is. Banks in particular will look at this ratio when deciding how much to lend you. Banks may also set a ratio band you must stay within for the term of the loan.
Current ratio is useful because it shows how your bills will be paid if your business doesn’t earn enough money. If you can’t pay what you owe, your lender or investor can sell your short-term assets to make up the shortfall.
Some industries have benchmarks for this ratio so you can check how you compare to similar businesses. Talk to your advisor about benchmarking.
Calculation
Debt to assets is your total liabilities divided by your total assets.
For current ratio, you can set up this equation in your accounting software or spreadsheet, or get your financial advisor to work it out.
Results
For debt to assets ratio, a result lower than 1.0 is good and shows your total assets are greater than your total liabilities, including debts. For current ratio, a result higher than 1.0 is good and shows you have enough current assets to pay current or short-term debts.
This makes you a safer bet for lenders and investors. Most importantly, it means your business model is on track.
If your current ratio result is below 1.0, you may need to fix it. Although it's based on a snapshot of your finances rather than the full picture, lenders and investors may see you as a riskier prospect.
But it also depends on what types of current assets you have. Cash is good for you and your business. Investors and lenders also like cash, or assets that can easily be sold for cash.
How to improve
To improve your current ratio:
- check the assets column in your balance sheet to see if your customers are paying you on time
- check your stocktake figures, and consider longer payment terms with suppliers so you can go through your inventory and sell your products faster
- check your liabilities: if you’re carrying a lot of credit card debt, switch this to a loan with a lower interest rate
- see if you can improve sales.
To improve your debt to assets ratio, consider leasing pieces of equipment instead of buying. Leased equipment is classed as an operating expense, not a liability, and it’s tax deductible. If you buy it, you own an asset used to make money for your business.
Quick ratio
A quick ratio is an equation that shows if your business can pay its short-term debts (called current liabilities on your balance sheet) from assets that can easily be turned into cash within 90 days, including:
- dollars and cents in your till or bank accounts
- accounts receivable
- pre-arranged overdraft.
For this ratio, inventory is subtracted as it can take longer than 90 days to turn into cash. Pre-paid expenses can’t easily be turned into cash, so leave these out too.
Why it’s useful
It’s reassuring to know you can easily free up money to pay debts or buy inventory. And if you can’t, you’ll know in advance to make other arrangements, for example, take out a loan or agree a payment plan.
Calculation
Do a stocktake, if applicable, as the equation below will use:
- value of your inventory (zero if you don’t have inventory)
- total of your current assets
- total of your current liabilities.
Results
A quick ratio higher than 1.0 shows you can afford to pay your bills on time and in full, with cash or assets you can easily turn into cash.
If it’s below 1.0, you’ll struggle to repay what you owe without borrowing money, running up credit card debts, or selling assets.
How to improve
To improve your quick ratio:
- check if you’re buying more stock than you can sell
- review your prices and marketing
- review your assets
- pay off your credit card on time to avoid paying high interest
- talk to your bank about restructuring your debts and paying interest only on a loan
- if your business earns enough to have a lot of extra cash waiting for the right time to use it, look into high-interest accounts.
Other equations
Depending on your industry or business size, there are other equations used to analyse performance.
These include:
- inventory turnover – the number of times stock is sold and replaced in a year
- return on assets – measures a business’s ability to make money from its assets, and typically only useful for banks
- return on equity – measures a business’s ability to turn an investor’s money into profit.
If any of these apply to your business, talk to your accountant or advisor about how your results compare to others in your industry.
If you have one, also talk to your board of directors or investors about ways to improve.
Learn more about