Using Ratio Analysis to Understand Cash Flow

Ratio and cash flow analysis are two of the most important tools used in underwriting commercial loans. This section combines the two with trend analysis to provide one of the most useful methods in determining a company's ability to repay debt and grow operations.

As discussed in the ratio analysis section, turnover ratios provide useful insight into a company's activities and health. Each of the three main activity turnover ratios, Account Receivable Turnover, Inventory Turnover and Accounts Payable Turnover, can be broken into two components: growth(/contraction) and management.  The growth component relates to the impact of increases (or declines) in sales on Accounts Receivable (A/R) and increases(or decreases) in cost of sales(or purchases) for inventory and accounts payable turnover. The management component measures how well these resources are being utilized. Let's review an example of accounts receivable turnover:

                                         2010                      2011                    2012                    2013
Sales                            $500,000               $650,000          $1,000,000          $1,050,000
A/R                               $ 70,000                $ 80,000           $  150,000          $  150,000
A/R Turnover (days)         51                          45                       55                         52


(A/R/Sales x 365) = Days

In order to determine cash impact of the management component of the ratio, the number of days for a period is held constant with the previous period, so in 2011 we would keep 51 days turnover from 2010. By changing the turnover ratio equation to determine accounts receivable, using current sales and the constant number of days from the previous period, we produce the following calculation:

Previous Period Days A/R *Sales (Current Period) /365 = A/R:
                      51 days * $650,000/365 = $90,822

Subtract this number from actual A/R to determine how well accounts receivable are being managed:                

                      $80,000 - $90,822 = ($10,822).  

In this case, better management of accounts receivable provided an additional $10,822 of cash flow in 2011.  Even though accounts receivable increased by $10,000 and therefore absorbed $10,000 of cash, if the days turnover had remained constant then it would have taken $20,822 of cash flow.  

We then make this calculation for each subsequent period

                                          
                                                        2011                 2012                  2013

A/R                                             $ 80,000           $  150,000        $   150,000
Sales                                         $650,000          $1,000,000        $1,050,000
A/R Turnover (days)                      45                      55                        52
A/R Turnover (Prior Period)         51                      45                        55

Prior Period A/R                                               $   80,000         $   150,000       
Current Period A/R                                              150,000              150,000
A/R Impact on Cash                                        ($   70,000)        $       -0-  

Proforma A/R based on PP TO                         $ 123,287         $   158,219
Current Period A/R                                             150,000              150,000    
Management Impact                                        ($  26,713)        $      8,219    

Sales Related Impact                                       ($  43,287)        ($      8,219)      
(Chg. in A/R - Man Impact)                                                            

In 2012 accounts receivable increased by $70,000. The two components, sales growth impact and management impact were ($43,287) and ($26,713), respectively. 

In reviewing accounts receivable in 2012, a banker should evaluate the aging schedule to help determine if there is a single receivable that may negatively impact the A/R turnover ratio. A large sale at the end of 2012 could negatively skew the ratio. If not, there was a significant deterioration in the management of accounts. Sales growth negatively impacted cash flow by ($43,287). 

Despite a slight increase in sales, account receivable remained constant at $150,000 from 2012 to 2013. Because sales increased slightly but A/R remained the same, there was a positive impact from the management of account receivable of $8,219. 

As bankers we expect accounts receivable to increase when there is an increase in sales. These increases absorb cash. A company that has negative cash flow from operations due to sales growth, may be an excellent candidate for some form of asset based lending. When sales growth slows, cash flow should become positive if all thing are held constant.   When accounts receivable balances grow due to poor management, then cash flow becoming positive remains questionable.            

The management impact on inventory turnover and accounts payable turnover should also be evaluated in the same way. An increase in inventory concurrent with a large increase in sales is expected, but a slowdown in inventory turnover due to poor management should be discovered prior to funding. 

By combining the three major activity ratios, the following formula can provide the cash cycle:

  A/R turnover ratio (days) + Inventory turnover ratio (days) - A/P turnover (days) = Cash Cycle 

This cash cycle evaluated over time can provide great insight into a company's cash flow.  As the cash cycle increases more cash is being absorbed than  what can be explained by just sales increases. 

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