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The Relationship Between Turnover Ratios and Cash Flow

Posted on May 16th, 2016

Jack Kern
Owner / President
Outsourced Accounting Department, Inc.

In my previous article, Profit vs. Cash Flow Made Easy,” I explained the relationship between the Profit & Loss and Cash Flow Statement.  In this article, I will talk about the impact of accounts receivable, inventory, and accounts payable turnover on cash flow.

To begin, these are the turnover ratios (expressed in days):

Accounts Receivable

Turnover

Inventory

Turnover

Accounts Payable

Turnover

____365____   

Sales

AR

 

________365_________   

Cost of Goods Sold

Inv.

______365______

_Inv. Purchases *

AP

* (Inventory Purchases = COGS – Beginning Inventory + Ending Inventory)

Below is a comparison of these turnover calculations based on the original data, with  (working backwards through the math) a pro forma based on the assumption of 30 days, 60 days, and 30 days, for accounts receivable, inventory, and accounts payable turnover respectively:

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Finally, below is a comparison of the original Cash Flow Statement, with a Pro forma Cash Flow Statement that is based on the accounts receivable, inventory, and accounts payable balances that result from the above assumptions:

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As can be seen, there is a dramatic improvement in cash flow from simply better managing accounts receivable collections, reducing inventory levels on hand, and as a result, keeping trade creditors current (and keeping the supplies coming in).

And one final note, as was discussed in several previous articles, if your books are maintained on a cash basis, then what is being shown as “sales” on your P&L is actually just your receivable collections – “apples and oranges” when if comes to understanding the true profitability of your business.  Instead, you should maintain your books on an accrual basis, and your true profit or loss is then reflected in your Cash Flow Statements as either a source of funds (profit, or funds flowing in) or a use of funds (loss, or funds flowing out).

 


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