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7 Financial Facts To Know About Your Business
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Article 6: How Much Cash?
How much cash or liquidity does your business need? It’s one of the most common questions small-business owners ask.
The answer depends on many factors and will vary from one company and industry to the next. For example, how fast do you sell your products or services? How fast do you collect from customers? How fast do you pay your suppliers?
To find the right answer for your company, you need to determine your cash conversion cycle. This is a guideline for liquidity that combines widely used financial ratios derived from your financial statements. The cash conversion cycle will tell you how much working capital you need to run your business without running out of cash.
Following is a step-by-step process for determining your cash conversion cycle:
Step #1: Determine your Days Sales Outstanding (DSO) and Days Sales in Inventory (DSI). DSO is the same thing as Accounts Receivable Days (AR ÷ Annual Sales x 365), measuring how long it takes you to collect your receivables. DSI (Inventory ÷ Cost of Goods Sold x 365) measures how long it takes you to convert raw materials or inventory into a sale.
Step #2: Determine how long it takes you to convert raw materials into cash. Do this simply by adding DSO and DSI. For example, if you had a DSI of 91 days (or an inventory turnover of four times a year) and DSO of 48 days (not unusual if you sell on net 30 day terms), it would take you 139 days to convert raw materials to cash.
Step #3: Determine how long it takes you to pay your receivables. This is the same thing as your AP Days (AP ÷ Cost of Goods Sold x 365). If we assume you’re paying suppliers in 30 days, then you need enough cash or working capital to cover 109 days of expenses (139 – 30 = 109).
The bottom line: Any cash that you have that covers more than 109 days of expenses is excess working capital, which you can put to work for your business by investing it in a short-term liquid business money market account. Any cash that covers less than 109 days of expenses is a cash flow shortfall, which may require financing to help cover.
Note: If your business operates without inventory, you can adapt this process by substituting the average length of time a project is engaged before being billed for DSI. If you provide service on an ongoing basis and bill monthly, this would be 15 days (30 days ÷ 2).
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