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Operating Cash Flow: Prime Indicators of Financial Crisis and How To Recover

03 Jul 2017






Every business objective is to grow and grow sustainably for long term profitability that makes it important to identify early signs of business financial distress and operating cash flow (OCF) helps you better detect prime indicators of financial problems to make sound decisions towards recovery.

Many business owners ask how to forecast business success? Or, what are the prime indicators of business success? These are good questions. 
 
But we believe, you can ask better questions that will help your business survive and thrive. Learning how to predict your business financial problems will help you determine preventive measures. Being aware of impending financial trouble can better help keep your company afloat and fully recover from financial crisis.
 
Your educated intelligence to predict future financial problems before it hits your business prepares you better not only for survival but to drive your business towards infallible success.
 
This takes us to the two biggest questions that we want to answer in this article to help entrepreneurs:
  • Can you predict your company’s financial problems?
  • How can your business recover from financial troubles?

 

Forecasting Financial Crisis: Finding Early Indicators  

Are there early warning signs that your business could be having serious financial problems?
 
The answer is: YES. There are actually multiple signs that could indicate financial problems if you know where to look. But more often than not, managers and even business owners ignore these signals. These signals are important to recognize that will help you drive your business towards recovery.
 
P. Scott Scherrer makes a strong point when he argued that 80% of business failures are a result of mishandled internal elements. He mentioned that cash shortage has always been associated with poor collections or lack of sales but the truth is, the usual transgression points to a problem buried deep in two business systems: management and bookkeeping information.
 
Another thing that significantly contribute to financial troubles include pricing. Many small businesses are pricing products or services without calculating the variable costs of production. It is important to consider calculating for the contribution margins, actual product costs, and direct cost of sales to derive a profitable pricing.
 
Before financial distress hits hard on your business, there are early danger signals occurring in stages, according to Scherrer. Table II below lists the common danger signals for your reference.

 

Source: P. Scott Scherrer
 
The first place you will have to look at is your financial statements. Your financial statements will tell you about the financial health of your company for a period of time.
 
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Signs of financial trouble could also be easily recognizable in your operating cash flow. If your operating cash flow shows negative numbers, it means that your operating expenses is higher than your operating income. This suggests that your company is incapable of paying the regular bills required to operate your business. 
 
When your operating income cannot pay for your operating expenses, cash in your bank account could be depleting and it will be a matter of time when your cash runs out and your business shuts down.
 
You will need to keep an eye on your balance sheet to identify the changes in your cash position. You may find your business in serious financial crisis if you have no entries of new capital coming from equity investors or lenders.
 
What you should remember is this: even with a profitable income, if your cash flow is negative, your business could be in financial distress. It happens to companies that enjoys profit and it could happen to you.
 
Now, you may be asking: what do you do to prevent that from happening? 
 
First, don’t wait too long for when you spend cash growing your business until you collect your cash receivables. Waiting too long drains your cash flow and that’s bad for business operations. It gets worse when your working capital starts to decline and shows negative numbers. Then, your accounts payable increases and if the increase is at a faster pace than your inventory, that signals your business is spinning down to financial trouble.

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Predicting Financial Problems: Significance of Operating Cash Flow

Operating cash flow tells you whether or not you can pay the bills your business incurred. 
 
It is the money generated from your regular business activities. Your operating cash flow should be able to pay for your operating expenses so you don’t run out of business and close down. This is the section in your quarterly and annual financial statements that helps you find indicators of financial problems.
 
Dugan & Samson (1996) studied the significance of operating cash flow and found it to have predictive power for financial distress. The authors examined Allied Products Corporation and found that—
 
“...the pattern of cash from operations may be indicative of financial distress and financial recovery before patterns discerned from net income. Changes in operating cash flow may provide useful information for managers and analysts.”
The authors suggest that the operating cash flow gives you a more accurate information relevant to your true financial state against income-based measures. They also suggest that if you see a steep decline in the OCF, this could mean that your sales is slowing down or you could be having some issues with cash collections. This is something you need to further investigate. 
 
Meanwhile, if your OCF increase is too high, you cannot right away conclude that it is coming from your regular sales. You should check your built-up inventory or this could also mean your account payables to suppliers and vendors are slowing down.
 
We took a closer look at their findings. The study centered on the Allied Products Corporation. To give you a brief company background, Allied Products Corporation did not declare bankruptcy. The company experienced staggering irregularity having a positive net income but running on a negative cash flow that brought it into a whirl of financial troubles. Perhaps, it is important to note that during the time of study, the company was exceedingly volatile in terms of sales and profit. It managed to increase sales and income but struggled with their cash flow that prompted the management to acquire large-scale financing from external sources. 
 
The company’s biggest struggle was to convert sales into cash flows. A comparison of pattern between net income and operating cash flow showed contrasting results. While the net income was positive, the company’s operating cash flow was negative. The authors also found that there was a three to four year lag between operating cash flow and net income, which led to the conclusion that the company’s changes in the operating cash flow trend helps predict the changes in pattern of the net income three to four years ahead.
 
For financial analysts, the operating cash flow is the preferred metric to determine the financial health condition of a company as it provides the current reality of the business operations. A good example would be if your business acquired a long term contract boosting its revenue yet, sales does not convert to cash right away, then it cannot be true profit until the company receives the actual cash in full.
 
But of course, we recognize that not everybody will agree to using operating cash flow to predict financial distress. Casey and Bartczak (1984) expressed their disagreement in their journal as they wrote,
 
“A study we have made of nearly 300 companies raises serious doubt about the reliability of operating cash flow as a financial indicator.”

Understanding Operating Cash Flow Analysis and Cash Flow Ratios

There are three major financial statements you should prepare at the end of every financial year. We have discussed that in the previous article. 
 
The thing is, most business leaders give greater importance to the profit or net income statements. That’s not a bad habit. But cash flow statement is equally important. 
 
When you run your financial analysis, the best way to achieve accurate forecast is to treat each of the concepts separately and look at it in different perspectives. Profit or net income is a different concept against cash flow. 
 
That said, you should not ignore the cash flow statement and should perform an independent analysis of your cash flow, which shows the amount of cash coming in and going out of your business. It may sound one and the same as the income statement. But it’s not.
 
The income statement uses accrual bookkeeping. This records all transactions, including all the amount that is not yet on hand. Say for example, you are seeing a $10 profit in your income statement but that amount may not yet be on hand, which means records of cash on the balance sheet does not show the $10 increase. Meanwhile, in your cash flow statement, if there is a $10 net cash inflow, it means that exact amount is on hand. That makes the net amount of cash from operations the true cash profit.
 
The general rule for small businesses is to operate with a positive cash flow. 
 
A cash flow analysis helps you determine the amount of actual cash you generated from your regular business activities. More importantly, it tells you if you are able to pay for your operating expenses that allows you to continue your business activities. On that account, taking a closer look at your company’s capability to actually produce cash can give you a better perspective to predict your company’s financial problems and determine how you can recover in an event of a financial crisis.
 
You must see by now that if your business has insufficient cash flow, it will not matter if your income statement shows profitability because your business operations is dependent on a positive operating cash flow. So, even if it seems that your business is profitable, if you have a negative cash flow, your business still suffers from financial crisis and could run out of business if you don’t take action to help it recover.
 
Your cash flow statement has three major sections: operating cash flow, financing cash flow, and investing cash flow. For the purpose of this article, we are only focusing on discussing the operating cash flow.
 
But for purposes of education, you can watch this video resource to help you better understand how cash flow from operations is computed and how it is different from cash flow from investing and cash flow from financing using a comprehensive example.
 
 
The operating cash flow specifically records the cash inflow and outflow from operating activities. It is calculated by the amount of cash generated from sales less the amount of expenses needed to operate your business activities. A positive cash flow from operating activities is preferred. But if you are running a tech company, you should expect a negative cash flow during the early years of production.
 
The cash flow analysis makes use of several different ratios but focus on cash flow ratios that helps you determine how solvent, liquid, and operative your business is.
 
 

Important Cash Flow Ratios

1. Operating Cash Flow Ratio relates to cash flow accrued from business operations to current business debt measuring the short term liquidity of the company. In simple terms, it helps you measure your company’s ability to pay for your current liabilities with cash flow generated from your business operations. Earnings can be manipulated but cash flow gives you a more accurate analysis of whether or not you have actual cash that can pay off your operating expenses and grow your business profitably. The operating cash flow ratio formula is,

 
Operating Cash Flow Ratio = Cash flows from operations / Current liabilities
 
To find the data for the formula above, you need your cash flow statement where you can get the cash flows from operations and the balance sheet where you can get the current liabilities.
 
Your operating cash flow ratio should be higher than 1.0. Otherwise, your company is in a serious financial trouble and may cease to operate. That means you are not generating sufficient cash to pay for your bills that gets your business to operate.
 
2. Cash Flow Margin Ratio helps determine the company’s ability to convert sales into cash and expresses the relationship between cash generated from operations and sales. The cash flow margin ratio formula is,
 
Cash flow from operating cash flows / Net sales = _____%
 
To find the data for the formula above, you need your cash flow statement where you can get the cash flow from operating cash flows and the income statement where you can get the net sales.
 
The higher percentage you get from the equation above indicates you have more cash generated from sales. In principle, if your cash flow is a negative number, you are losing money even if you are generating sales revenue. For your business to continue its operations, you will need to raise the money however possible such as through investors, lending, or bank loans to pay for your bills like your inventory and all other accounts payable relevant to your business operations.
 
3. Cash Flow from Operations / Average Total Liabilities helps you measure how solvent your company is that determines whether or not you can pay your debts and keep afloat. The cash flow from operations to average total liabilities ratio formula is,
 
Cash flow from Operations / Average Total Liabilities = _______% 
 
To find the data for the formula above, you need your cash flow statement where you can get the cash flow from operations and the balance sheet where you can get the average total liabilities.
 
The higher percentage you get from the equation above is good indicator of your company’s financial flexibility. It also means your company has the ability to pay for its debts.
 
4. Current Ratio helps you measure how liquid your company is and tells you whether or not your current assets sufficiently covers your current debt. The current ratio formula is,
 
Current Ratio = Current Assets / Current Liabilities = ______X
 
To find the data for the formula above, you need the balance sheet where you can get the current assets and current liabilities.
 
The answer to the calculation above determines the number of times that your company can fulfill its short-term debts. Let’s insert some figures into the formula for better clarity such that if your company has current assets amounting to $200 and current liabilities at $100, the result gives you 2.00X which means that your company has the ability to pay the current liabilities from its current assets two times over. That’s a good figure placing your business in a good position because it can cover its debt obligations. If the result gives you 1.00X, it could suggest some financial problem and you should be working on improving your current assets value or reducing your current liabilities.
 
5. Quick Ratio (Acid-Test) is a liquidity test that excludes inventory. It helps determine your company’s ability to pay for short-term obligations with ready cash such as accounts payable, taxes, and wages. The quick ratio formula is,
 
Quick Ratio = Current Assets - Inventory / Current Liabilities
 
To find the data for the formula above, you need the balance sheet where you can get the figures for current assets, inventory and current liabilities. A quick ratio result of less than 1.0X suggests that your company has $1 of liquid assets available to pay each $1 of current liabilities, suggesting that you may need to sell inventory to pay for short-term debts. Higher the quick ratio suggests better financial position for your business.
 
What we learned from scientific journals is that a considerable number of literature found relevance of the cash flow ratios in predicting financial distress. A recent study by Fawzi, et al., (2015) affirms that “cash flow ratios are reliable tools to predict financial distress.” Although the study focused on the Malayan context, it could well apply to global businesses.
 

Reversing Directions: Recovering from Financial Troubles

In an event that you miss to calculate financial troubles and find your business in a downward spin financially, recognizing your financial problems would be a good place to start.
 
The obvious culprit that sends you to a painful financial slump is your lack of cash flow. When you run out of cash, your business ceases to operate. But you should be able to detect multiple signals of financial distress from your financial statement. It will be wise to go back and analyze them. Identifying key indicators of financial problem could help you plot your course of action towards recovery. 
 
You may think that during a financial crisis, it is unwise to get help. Wrong.
 
During a financial crisis, it is the perfect time to get help if you are determined to survive. Hiring a qualified financial advisor to help you is a necessary investment because the risks far outweigh the costs.
 
You will need your financial advisor's professional experience in developing a monthly operating plan with a detailed plot of your financial operations, which may include the following activities:
  • backlog production 
  • accounts receivable collection
  • accounts payable payment plan
  • operating expenses payment plan, and 
  • any other financial obligations, such as bank debt payments
 
Another important factor is to manage your cash flow. Your operating costs should be analyzed for you to determine which items you can reduce or remove. Cutting your expenses can help improve your cash flow.
 
While there are many other steps you can take to fully recover from your financial problems, we focus our discussion on the initial you can take to shape your recovery plan. But we found this helpful diagram published in the Government Finance Officers Association of the United States and Canada, which suggests three basic stages towards recovery from financial distress. 
 
It may seem inapplicable to private business entities, but the framework provides the basic steps that will guide you to a successful reform and transformation.
 
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Source: GFOA Organization
 
Step 1. Bridging. Perform the diagnostics of your financial problems.
Step 2. Reform. Carry out short-term plans for recovery such as plotting your operating plan.
Step 3. Transform. This is the stage where you develop long-term goals to strengthen your financial position and conceive a business model adaptable to changing environment.
 
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