CashFlowABC Episode 9 – Key Performance Indicators

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May 292009
 

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In any business setting, you need to be measuring appropriate Key Performance Indicators (KPI’s) to keep on top of the performance of the business.  The basic process for utilizing KPI’s is:

  • Identify what measurements are most important to your business
  • Measure the “current state” of the KPI’s
  • Establish targets for where you want them to get to
  • Measure the KPI’s on a regular (usually monthly) basis
  • Analyze the results and identify opportunities for improvement
  • Hold employees accountable for the numbers that they are responsible for

Working Capital
Working Capital (WC) is Current Assets minus Current Liabilities.  It is a measure of how well you churn cash through your organization.  The two largest components of WC are Accounts Receivable and Inventory.  If your inventory is too high, you are probably paying cash out too early and if A/R is too high, you’re not collecting fast enough.

Working Capital Turns
WC Turns are Sales/WC.  It is a measure of liquidity and how well you utilize your WC.  Higher turns are better – it indicates that you are converting your investments in the business into cash quickly.

Inventory Turns
Invetory Turns are calculated by Cost of Goods Sold (COGS) / Average Inventory.  Higher turns are better.  6 turns means that you turn the inventory six times per year or, conversely, you have two months of inventory on hand.  This ratio indicates how quickly your business is turning over inventory.  A high ratio may indicate positive factors such as good stock demand and management. A low ratio may indicate that either stock is naturally slow moving or problems such as the presence of obsolete stock or good presentation. A low ratio can also be indicative of potential stock valuation issues.

Days of Inventory
This is a sister to Inventory Turns – just expressed in days.  The calculation is 365 / Inventory Turns.

Accounts Receivable Turns
Accounts Receivable (A/R) Turns are a measure of how quickly you are turning sales into cash. The calculation is net sales ÷ average trade accounts receivable.  High ratio means shorter time between sales and cash collection. Lower means the opposite. If ratio is lower than peers, the quality of AR should be examined. Note that ratio may be affected by seasonal fluctuations in sales or if a large portion of sales are cash based.

Days Sales Outstanding
Probably the most prevalent of the A/R related KPI’s.  There are several ways to calculate DSO, including the clawback method, but the most common is 365÷ A/R Turns.  DSO is an expression of the A/R turns in terms of days rather than annual cycles.  The higher the number, the greater the probability of delinquencies. Interpret this in line with the company’s credit and collection policy or payment terms.

Past Due Percent & Past Due Dollars
These are two different measurements, but I list them the together because they should always be looked at together.  Past due percent is the past due dollars divided by the total A/R.  Because of fluctuation in sales month to month or quarter to quarter, the percentage can be skewed one way or the other by the fluctuation in sales.  When analyzing the past-dues always look at both together or you’re only getting half of the picture.

For further assistance in measuring your KPI’s check out the Financial Analysis templates in Excel from InstantController.

For monthly A/R tracking templated with graphs that are ready for your data, check out the A/R Management Bundlefrom InstantController.

- John

 Posted by at 7:08 am  Tagged with: ,

CashFlowABC Episode 8 – Economic Order Quantities

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May 152009
 

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EOQ is a method for setting a consistent order quantities that both minimize ordering and inventory carrying costs.  EOQ can be used hand in hand with reorder point systems as they function under similar assumptions:

  • That demand is relatively constant and known.
  • The order quantity is usually the same.  (The EOQ will remain constant until the review period or if changes in the supply chain warrant a reformulation of the EOQ.)

EOQ has some additional requirements and assumptions:

  • The product is purchased or produced in batches or lots.
  • Order preparation costs are known.
  • Inventory carrying costs are known.
  • Annual usage is known.
  • Replenishment occurs all at once.

Let’s look at EOQ’s requirements and assumptions one at a time:

  • The assumption that the product is purchased or produced in batches or lots is due to the consistent nature of the EOQ and the demand that determines it.  In other words, you won’t be ordering 7 now, 3 tomorrow and 12 next week.  The EOQ is formulated and is set until the next review period.  However, if the EOQ calculates to a number not divisible ty the batch or lot size you will need to round the EOQ up to a quantity divisible by the batch or lot quantity.
  • You will need to know your order preparation costs.  This holds true for both purchased and manufactured items.  You’ll need to know:
       – The number of orders placed annually.  This is determined by the annual demand / the standard order
         quantity.  If there is no standard order quantity use the average order quantity understanding you will need
         to review the EOQ sooner than anticipated.
      – How long it takes to process an order and the overhead costs associated with that process such as employee 
         salaries and the costs of purchase orders.
  • The inventory carrying costs in the EOQ are expressed as a percentage of the average annual inventory.  The inventory carrying costs fall into 3 main categories with the following sub-categories:
      – Capital
         – Inventory capital
         – Insurance
         - Taxes
      – Storage
         – Handling
         – Security
         - Storage
         – Record keeping
         – Space
      – Risk
         – Deterioration
         – Theft
         – Obsolescence
  • You will need to know your annual usage.  If that isn’t known you can extrapolate the data but you will need to review the EOQ sooner than anticipated.
  • Replenishment arrives and is ready for use all at once.  No partial shipments or a portion of the order quantity held in a QC queue for example.

 The calculation for the EOQ is: the square root of 2 x the annual demand x ordering costs / annual carrying costs x the unit costs.  As an example:

Annual usage = 1,000,000

Ordering costs = $5

Inventory carrying costs (as a percentage) = 0.20 (20%)

Unit costs = $2

Square root of:

2 x 1,000,000 x 5 / 0.20 x 2  or…

Square root of:

10,000,000 / 0.40  or…

Square root of:

25,000,000

EOQ = 5,000

If you wish to lower your EOQ you must take into account the following:

  • As your annual demand increases so does your EOQ to satisfy the increased need.
  • If your inventory carrying costs decrease your EOQ will increase as it is now more cost efficient to carry more inventory compared to unchanging unit costs and ordering costs.
  • If the unit costs decrease your EOQ will increase as it is now more cost efficient to purchase more inventory compared to unchanging carrying costs and ordering costs.
  • If you decrease your ordering costs your EOQ will decrease as it is more cost efficient to place more frequent orders compared to unchanging carrying and unit costs.

So, to lower your EOQ batch size you must lower your ordering costs.  This can be achieved through applying lean principles or mapping the process, identifying the waste and then removing the waste from the process.

If the EOQ assumptions and requirements are not valid for your company there are many other methods for ordering replenishment but you should always use a method that will keep your carrying costs and ordering cost to a minimum.

 Posted by at 2:30 am  Tagged with: ,

CashFlowABC Episode 7 – Principles of Cash Savvy Business Management

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May 132009
 

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Asset protection

Form an LLC or incorporate to protect your personal assets - Don’t comingle.  Use a business entity to separate your personal and business self.

 

Priorities

Payroll first – pay your employees first or they will soon be former employees.

What will generate cash?  Figure it out and and pay those bills first to generate the short-term cash flow and keep the cash churning.

 

Communication

Don’t vanish – keep the communication going with your suppliers, customers and employees.  No matter how bad it is, never let them see you sweat – always be confident or they won’t be confident either.

Kill the rumor mill – as the environment gets worse, the rumor mill will take on a life of it’s own.  Show confidence and kill the rumor mill before your competitors start feeding it.

 

Use the business’ resources

Customers – look for sales and prompt-pay opportunities.

Suppliers – look for sales, return opportunities as well as extended terms.

 

Cut the crap

Fire-sale the overstock – it’s time to get rid of the crap that you’ve been leaving in the back of your shop -turn it into cash!

Look at new opportunities on Ebay, Craigs List, etc..

 

Think unconventionally

Can I leverage what I do into other markets?  This is a great opportunity to grow the breadth of your business doing the things that you already know how to do!

  

Cost control

Don’t throw the baby out with the bath water – control the costs rather than cut them.

Employees – take care of them!  If you’ve normally bought lunch every Thursday try to continue it to avoid throwing up a red flag with your employees.

Marketing – This goes along with not throwing out the baby with the bath water.  Tough times are when most companies cut back, but the ones who do the best and recover the strongest are the companies who come out of the funk with a strong marketing effort.

 

Loan covenants

Don’t let them bite you – If you’ve normally not had to worry about your covenents, they can sneak up on you really quick if you’re not careful.

Work with your banker – Your banker wants you to succeed too!

 

Cash forecasting

Start small – 4 weeks:  It’s tough (and inaccurate) in the beginning until you get over the initial learning curve.  As you get better at it, start extending out into the future.

 

Grow – 8 weeks:  If you can effectively forecast cash eight weeks out, you are probably miles ahead of the competition.

Triumph – 13 weeks:  13 weeks is the goal of most cash forecasts – that’s three months!  Of course, the further out it is, the less accurtate, but it at least starts to paint the picture.

– John

 Posted by at 6:54 am  Tagged with: ,
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