If you are running a business, you are generating income and paying for things like, payroll, equipment, marketing, and more. With a constant inflow and outflow of money, it becomes imperative for small business owners like yourself to make sure more money is coming into the business than what’s leaving out of the business. This flow of monies in your business is referred to cash flows. Unfortunately, far too often, it is ignored by business owners until they are at the brink of a closure, bankruptcy some other despair. This article will highlight who may be wanting to understand your cash flows even if you’re not, and how it’s analyzed.
Who Cares About Cash Flows?
There are at least five major groups of people who are interested in your business’ cash flows:
Creditors – bank loan officers, for instance, want to determine your ability to pay your debts
- Investors – this group is interested in the potential return they can expect based on your cashflow assessment
- Management – as a business owner, you and your managers would want to understand your business’ financial health, identify areas for cost cutting, etc.
- Guarantor – business owners will want to determine their own cash flow potential
How is cash flow analyzed?
In general, cash flows are analyzed using financial statements. Most banks use accrual-based financial statements versus cash-based financial statements. Accrual based is an accounting term that means that revenue is calculated by the amount invoiced to your customers and expenses include accrued expenses that have not yet been paid. Cash flow can also be determined using a company’s tax returns as well. There are a number of cash flow models. The most traditional of these models is EBITDA – earnings before interest, taxes, depreciation and amortization.
After earnings is calculated using EBITDA (versus your gross income) the cost of your business’ debt payments and interest is subtracted to obtain, what is called your margin. EBITDA and the margin are used to determine an important ratio that banks will use to see if your business’ cash flow can cover the cost of debt – Debt Coverage Ratio or DCR. Typically, a bank will want to see a DCR of 1.20 or higher. This means that for every $1.20 coming IN to the business, $1 goes out. DCR’s of lower than $1 would mean your company’s expenses are greater than your revenue. This type of “bleeding” over a continued period of time would be detrimental and could lead to business closure.
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