Data shows that most businesses fail due to cash flow problems. The goal of any business is to make a profit, but cash flow is necessary to continue operating.

It’s sometimes difficult for start-up businesses to both generate and hold on to cash. This is often due to the debt that is incurred and the cash that is needed to both fund operations and pay off debts.

Understanding free cash flow and ratio analysis helps owners manage their cash and debt. It’s also important to understand cash budgeting, cash-flow management, and the cash-to-profit relationship.

Free Cash Flow

This is the amount of cash a business generates after accounting for:

  • Operating cash flow – cash generated from operating
  • Capital expenditures – money spent on your fixed assets
  • Seasonal working capital – the difference in working capital between periods
  • Dividends – shareholder payments, if any

Free cash is the cash you have leftover that you could do something with.

Consider the concept of the time value of money. A dollar today is worth less tomorrow, and worth more if you do something to make it work for you. This is the purpose of free cash concept—to find a way to make your unused cash work for you.

Free Cash Flow = Operating Cash Flow – Working Capital – Capital Expenditures – Dividends

Ratio Analysis

Financial ratio analysis helps you determine how liquid your firm is. In other words, or how successfully will your business meet its short-term debt obligations. Liquidity is your firm’s ability to pay its short-term debt obligations.

The two most commonly used ratios to determine liquidity are current ratio and quick ratio.

The current ratio helps determine the ratio of your current assets to your current liabilities. Current assets include cash, accounts receivable, and inventory. Current liabilities are bills you owe, generally within 90 days.

Current Ratio = Current Assets ÷ Current Liabilities

The quick ratio allows you to determine if you can pay your short-term debt obligations, or current liabilities, without having to borrow or sell any inventory.

Quick Ratio = (Cash + Marketable + Securities + Accounts Receivable) ÷ Current Liabilities

You can use accounts receivable turnover to measure your inventory-to-accounts receivable cycle.

Beginning and ending account receivable refer to the value of these accounts at the beginning and end of the period.

Accounts Receivable Turnover Ratio = Net Annual Credit Sales ÷ ((Beginning Accounts Receivable + Ending Accounts Receivable) ÷ 2)

Cash Budgets

Prepare a monthly cash budget to track your cash. Create cash flow statements at regular intervals to analyze your cash flow. This helps you budget the amount of cash you can use for the various activities in your business

The purpose of a cash budget is not to set targets for cash but to anticipate needs. If you prepare cash budgets 6 – 12 months in advance and your needs change, you can change your cash budgets.

Cash budgets address “what-if” scenarios. For example, if you changed the speed of your collections or the timing of your inventory purchases, you can predict the general outcome of a change related to cash collection or generation.

How to Maximize Your Cash Flow

Inventory and accounts receivable are two of your current asset accounts that significantly influence cash. Inventory is usually the products you sell. Accounts receivable represent the credit you extend to customers. Selling inventory and collecting receivables more quickly boosts your cash flow.


Another short-term strategy is to time your accounts payable. Pay your accounts payable on the day they are due, not before. This gives you the ability to use your cash while you have it.

However, use caution when using this technique. Consideration of your suppliers is reasonable. They have to pay bills as well. To maximize your cash usage and boost your supplier relationships, negotiate your payment dates with them to allow you to hang on to your cash longer and make your payments on time.

Cash vs. Profit

Cash flow and profit are not the same. Financial accounting is not focused on cash flow. It is focused on net income or profit. Profit and cash flow are related in that profit is part of your cash flow, and it is what is left over after paying your obligations.

For example, when you make a sale to a credit customer, you recognize that sale immediately in your accounts. You enter a debit for your inventory and a credit for your receivables. You may not receive cash immediately.

According to your accounts, you have made a profit. However, you do not have the cash for the sale yet. The gap between profit and cash flow may be large. If you have rapid growth in credit sales, profit may far exceed cash received.

Keys to Good Cash Management

The bottom line to good cash management is staying informed with the tools available to you. Understand how your cash flows into your business and create a cash budget to give you a healthy cash balance.

As economists buzz about a looming recession, having a healthy cash flow will see you through tough economic times. Learn more about surviving a recession. When you find yourself with a cash flow deficit, contact Allied Financial Corporation of Delaware Valley for an accounts receivable line of credit. Check out the other benefits of an accounts receivable loan. Contact us for more information.