Calculating Your Business’s Operating Cash Flow MarginYou can keep tabs on how profitable your business is by knowing your cash flow margin. Here's everything you need to know to calculate it for yourself.
Your business’s operating cash flow margin is an important measure that shows you how stable your earnings are. For example, if you’re making $25,000 per month in sales, but half of those sales are being returned on the regular — that’s not a good cash flow.
By calculating your operating cash flow margin, you can keep tabs on how profitable your business is. This number tells you how much of your sales convert to cash, which you then use to cover your expenses.
Being aware of your cash flow numbers is also a way to prepare if you’re considering expanding or applying for a loan. Potential investors and lenders will scrutinize this margin. It’s a smart idea for you to know it better than they do.
The cash flow factor of your business’s success breaks down into profitability ratios. These numbers show how efficient your performance is. The ratios then divide into the margins and returns.
There are courses dedicated to teaching you how to use this formula and the others necessary for running a business. But we’ll break it down into easy-to-digest pieces for you so you can skip going back to school for now.
1. Terms You Should Know
Before we delve into analyzing the cash flow, it helps to know exactly what you’re learning about. If you have a bookkeeper or an accountant handling your finances, you may not have run into these terms yet.
However, as a business owner, you should know what they’re doing and how your expenses and income are operating. As you review your reports and determine your business’s cash flow margin, there are some accounting terms you’ll see.
Essential Business Accounting Terms
Before you start reviewing any itemized reports from your accounts receivable software, use this short glossary to preview what you’ll see:
- Cash flow – How your money moves, either physically or virtually, throughout your business. This could be from one bank to another (via an expense or income payment) or withdrawn into your hands directly (bank to person).
- Earnings quality – The quality of your earnings is a measure of how consistent your profit is. When you make a sale, do you get to keep the profit? Or do you have frequent returns to deal with? The earnings quality works to predict how your business will do in the future.
- Margins – The term “margin” is different in business than in daily vocabulary. It’s used to analyze the difference between how much it costs the seller to acquire their product or offer their service and how much they sell it for. A comfortable profit margin helps buffer slower periods and inflation. Your business’s product sales margin is a percentage of your net sales revenue.
- Returns – It might surprise you to learn that returns aren’t always a bad thing in business. The term “return” refers to the change in price over time of something. Your assets, investments, and services have a value to them that varies. If the value is a positive return, you’ve made a profit. A negative return is a loss.
- Depreciation – Depreciation discusses the decrease in fair value of an asset. For instance, a car’s valuation depreciates from the instant you drive it off a car lot. It also refers to how the original cost of your asset declines in value over a period of time.
- Free cash flow – The cash you have on hand isn’t necessarily free to use how you want. Your “free cash flow” is how much money your business has after operating expenses and maintenance come out. Learn more about this in our Cash Flow Estimation Guide.
- Operating margin – A business’s operating margin is a formula that evaluates the ratio of your operating income to your net sales. As a formula, it looks like this:
Operating margin = Operating income ÷ revenue
- Net profit margin ratio – This formula measures how much net income your business has generated. It’s a percentage of the revenues received and is a significant indicator of how financially healthy your business is. As a formula, net profit margin looks like this:
Net profit margin = (Revenue – cost) ÷ revenue
- Operational leverage – This term refers to how a business owner can increase their operating income via increased revenue. For instance, if your company has a high gross margin of sales, combined with low expenses to operate, it would have high operating leverage.
2. Calculating Your Cash Flow Margin
Whether you’re in business or working for someone, you want to make a profit after paying your expenses. But determining this profit as a business owner is more complicated than as an individual.
Watching your cash flow ratio is a vital way to get a feel for your business’s profitability. It’s a ratio that tells you how your company manages its sales and turns them into cash.
Until you know how much of your cash is “free” to use, it’s impossible to see if you’re making a profit. You can have tens of thousands of dollars coming in every day, but you don’t have a profit if you’re spending that amount plus more to operate.
Calculating Cash Flow Margins
Use this ratio to determine how efficiently your business is performing. The profitability formula divides into margins and returns, helping you break down your cash flow margin in detail.
The part of the ratio that focuses on margins tells you how well your business is turning sales into profits. You can’t separate your cash flow from operating activities until you know how much of your sales are sticking.
Making a lot of sales is one thing. But if you’re not charging enough to show a positive return, your business isn’t running efficiently. This is a red flag to investors, lenders, and shareholders.
The operating cash in your business is how much it generates in revenue after long-term investment costs. This would include anything you pay to your suppliers, production labor, and non-cash expenses.
A financial analysis of your net sales is then calculated. Find this by determining how much money you earned in sales before deducting the cost of providing the goods or services. Gross sales include returns, promotions, and discounts; net sales do not.
You’ll need these numbers to determine your company’s cash flow margin.
Once you have them, plug them into this formula on your balance sheet:
Operating Cash Flow Margin = Cash Flow From Operations ÷ Net Sales
If your net sales increase, the operating cash flow margin would decrease, and vice versa.
But what do you do with this number once you have it?
Related Reading: Understanding Incremental Cash Flow vs. Total Cash Flow
3. What to Do With Your Cash Flow Conclusion
Once you know what your net profit is and how efficient your cash flow margin is, you can plan your next business strategy from there.
If your sales revenue is coming in consistently, without a lot of returns, your net profit margin is solid. Your sales are turning into profits once the expenses are taken care of.
But if the cash flow is erratic or negative, your business strategy needs readjusting.
Let’s look at an example as a fictional lumber supplier analyzes their operating cash flow results.
The supplier specializes in hardwood lumber, selling each piece at an average of $22 per board foot (BF). This year, the company sold 400,000 BF, giving the company a gross income of $8,800,000. After expenses of $8 per BF ($3,200,000), the company’s net income would be $5,600,000.
However, other expenses and overhead for the company totaled $5,400,000. The company had to invest in new machinery at $400,000. This puts them in a bind at a $200,000 negative return and no free cash flow.
The business owner must use this metric to decide how to move forward to turn a profit. There are quite a few ways, as an owner, you can improve your business’s operating cash flow. Our fictitious lumber company will have to choose at least one of these to get them out of the negative.
4. Tips to Improve Your Business’s Operating Cash Flow
As you’re in business longer, you can look for patterns in your income statement and other reports. As you see your business operating cash flow declining, you can jump on it quickly before it becomes a problem.
Depending on the severity of your reduced cash flow margin and predicted decline, you may have to take drastic measures.
Before you start laying off employees or taking out a loan, try one or all these tips:
Lease Expensive Equipment Instead of Buying It on Credit
Leasing isn’t always the best business move, but with equipment, you can deduct your leasing costs in your taxes. It’s also easier to finance a lease if your small business’s credit rating isn’t spectacular.
Adjust Your Invoicing Terms
You may have been too lenient in the past, allowing clients to pay late without a penalty. A late fee may help you speed up invoice payments.
If you extend credit, put a smaller cap on how much you allow for clients that routinely pay late. Let them know they can earn their way to a higher credit limit by paying on time.
Work With an Accelerated Invoicing Company
When you’re going through a rough patch, it’s tempting to turn to a traditional bank loan to carry you through. This often creates more trouble than it’s worth. Now you have long-term monthly payments to correct a short-term problem!
If your business uses invoicing, working with an accelerated invoicing company, like Now, is a better strategy. For a small fee, the company purchases your outstanding invoices from you. It’s money you’re already owed, so there’s no loan involved.
You get the working capital you need to cover your expenses until business is back to normal. The invoicing company collects their money from the client directly. It’s a mutually beneficial business agreement without confusing interest rates and repayment terms.
Offer More Payment Options
If it’s not easy for a client to pay your invoice, you’re going to get pushed to the back burner.
We all have to admit to being a tad bit spoiled with all the conveniences available today. The “click and pay” options or automatic withdrawals make it so much easier to manage our bills!
If your invoice requires a check in the mail, or your online payment system is confusing, the client may wait until they “have time” to deal with your bill.
On the other hand, if they get an email and can click on a link, save their payment method, and press a button, they’re more likely to go ahead and pay right then.
Offering other easily payable options besides a debit or credit card helps, too. Many people prefer to pay through PayPal, ApplePay, and other online sources.
Reduce Your Expenses
Try to reduce your operating costs by researching suppliers. Change to someone who can give you the same or comparable goods for less.
If you’ve been loyal to one company, negotiating a better rate might be an option. Let them know you’re looking into cutting costs and you found another company that’s cheaper. You’d prefer to work with your current supplier but would like to negotiate your terms.
Analyze your expense report through your accounting software.
Where else can you cut your budget to free up some cash flow?
Raise Your Prices
Pricing your product or service is a crucial part of your business. If you charge too much, consumers will go elsewhere. Not charging enough means you won’t be able to make a profit.
There’s a sweet spot somewhere in between if you study the market for your product.
When you consider what the consumer is paying, you also have to take into account taxes, shipping, and handling. The total amount should be comparable to the going market rate at the time.
Research what your competitors are charging for the same thing you provide, including shipping and handling. Taxes are non-negotiable and thus need considering in the total amount paid as well.
If your rates are reasonable compared to other businesses in your industry, a small price hike is acceptable. When you have a good reputation and rapport, most clients will continue to work with you. It’s easier to pay the small extra charge than find someone new.
While it’s not much to them, it can be business-changing for you, expanding your growth rate. Think about a one-dollar increase for your services or goods. If you sell 100,000 items this year, you’ve now made $100,000 more to include in your net profit.
Tweaking your processes to increase a negative cash flow margin doesn’t have to be drastic. These minor adjustments can save you, or make you, major money.
Knowing your business’s numbers is an essential part of your overall success. You may need the cash flow margin to show to potential investors or lenders or simply to get a feel for the efficiency of your company.
When you know how to read financial statements and determine your business’s operating cash flow margin, you can make big decisions for your future.
Set up your NowAccount today and start reaping the benefits of accelerated invoice payments!