What does all this jargon mean? Here are some (simplified) cash flow terms and definitions you may come across when operating a business:
Cash: Cash includes currency, the reconciled amount of money in the company’s bank accounts, and items negotiable for cash, such as checks and bank drafts. Cash may also include certain temporary short-term investments that can be quickly converted into cash, such as government-issued treasury bills.
Current asset: An asset by definition has future economic value to the business. Current assets are expected to be converted into cash or used within an operating cycle of the business. For most businesses an operating cycle is one year. Current assets typically include customer and other accounts receivable, inventory for resale, and prepaid assets, as well as cash.
Current liability: A liability represents an obligation by the business to pay. Current liabilities are expected to be paid within a business operating cycle. Trade accounts payable, employee wages, short-term loans, and taxes are some examples of current liabilities.
Long-term asset/long-term liability: These are other assets and liabilities that are not expected to be converted into cash, consumed, or paid within a business operating cycle. Examples of long-term assets are plants, equipment, and buildings. Long-term liabilities include long-term loans, such as a mortgage that is due in five years.
Net working capital: This is current assets less current liabilities. For most financially healthy businesses, this should be a positive number.
Current ratio: The current ratio is current assets divided by current liabilities. It should be at least 1, and preferably higher. Knowing your ratios can warn you of impending trouble. What is considered a good ratio or a bad ratio will vary depending upon your type of business. If you sell left-handed widgets and your golfing buddy is a lawyer, you can’t brag that your whatzit ratio is bigger and hence better than his, because such a comparison is meaningless across disparate industries. It makes more sense to compare your widget-selling financial ratios with those of another widget seller. Sometimes you can get this information through an industry trade association, which compiles and publishes aggregate financial statistics of members.
The best comparison is with yourself. Compare the ratio this month with the one from last month or last year. That will give you a good idea of whether liquidity and cash flow are improving under your financial management or whether things are looking worse.
Quick ratio: The quick ratio is current assets, less inventory, divided by current liabilities. Since inventories can sometimes be difficult to liquidate, the quick ratio is considered by some to be a better measurement of a business’s ability to pay its bills than the current ratio. The quick ratio is sometimes called the “acid test” ratio.
Accounts receivable: Accounts receivable represents money owed to you by your customers.
Accounts receivable aging: Aging is accounts receivable analyzed by due date. Typically the due dates are grouped by monthly periods, such as 30, 60, 90, and 120-plus days past due. If your 120-plus aging is usually under 1 percent of total receivables but has recently jumped to 5 percent, it indicates you are developing a collections problem.
Accounts receivable days sales outstanding: Days sales outstanding is the accounts receivable divided by the average daily sales. It’s a measurement of how quickly a business collects its account receivables, so a lower number is better.
Inventory: Inventory is usually the cost of the products a company holds for resale to customers. It includes not only finished goods but also raw materials and goods in production.
Slow-moving stock: These are products in inventory that are selling at lower than expected rates. If a business expects to keep a product in inventory for an average of no more than 60 days before selling it, a product with six months worth of sales in stock would be slow moving.
Stock-out rate: A stock-out happens when a customer order cannot be filled because there is no product available. A stock-out rate is the number of times this happens for every 100 product orders. A high stock-out rate may create a risk of losing sales to customers who are not willing to wait for the business to replenish its stock of inventory.