Rules
Part of Reading cash flow statements with a sceptical eye
Cash flow metrics worth trusting: conversion, working capital, real runway
Cash flow metrics worth taking: cash conversion, the working capital decomposition and runway computed from committed outgoings rather than an average month.
A cash flow statement is a history. The measures taken from it turn that history into something you can act on. There are fewer of them than in most of accounting: four or five that matter, and a couple that sound useful and mislead.
What follows is each one with its arithmetic, an invented example, and the thing it is actually telling you. None of these figures is a benchmark and none should be compared with another business.
What to take away
- Cash conversion, the share of profit that turned into cash, is the first measure to take and the one that provokes the right questions.
- Runway is arithmetic, not a forecast, and it should be computed from committed outgoings rather than from an average month.
- The working capital movement is worth decomposing every period. Which of receivables, payables or stock moved is a more useful finding than the total.
Cash conversion
Operating cash flow divided by operating profit.
Say operating profit for a period is 50 and operating cash flow is 33. Conversion is 66%. Two thirds of the profit turned into money; the other third is sitting in receivables and on shelves.
There is no correct figure; what matters is the direction over several periods and the reason for any large gap. A business converting most of its profit is funding itself, while a business converting a small share is growing its working capital.
That capital is either an investment it chose or a collections problem it has not noticed. If it is the second, see the accounts receivable guide.
Conversion above 100% is worth reading carefully rather than celebrating. It usually means payables grew, which is to say suppliers funded the period. That is fine once and a warning if it repeats.
Decomposing the working capital movement
Take the three lines separately every period, because the total hides which of them moved.
Working Capital Movement Breakdown
- Receivables-25
- Payables+8
- Stock-6
- Net-23
| Line | Movement | Effect on cash | Reading |
|---|---|---|---|
| Receivables | Up 25 | (25) | Invoiced more than collected |
| Payables | Up 8 | 8 | Invoiced by suppliers more than paid |
| Stock | Up 6 | (6) | Bought more than sold |
| Net | (23) | Growth absorbed 23 of cash |
The net figure of 23 is what appears in the statement. The three lines are what tell you what to do. Receivables up 25 on flat sales is a collections issue; the same movement on sales up by a third is the ordinary cost of growing. Stock up 6 might be a deliberate buffer or three deliveries nobody needed.
Runway
Cash available divided by the net cash going out each month.
Runway With Annual Insurance
- Month 0Cash 60, monthly burn 7
- Month 3Annual insurance 14 due
- Month 6Runway ends after insurance
- Month 8Runway ends without insurance
The arithmetic is trivial and the inputs are where people get it wrong. Cash available means cash plus anything genuinely drawable, not receivables. Which of your balances that includes depends on the accounts themselves, and the public guidance on opening a business bank account is a plain description of how those are usually arranged.
Net outgoing should be built from committed costs plus the payments you already know are coming, not from an average of recent months, because averages smooth out exactly the quarterly and annual payments that cause the problem.
An invented case. Cash of 60, committed monthly outgoings of 22, expected receipts of 15, so a net burn of 7. Runway is a little over eight months, until you add the annual insurance of 14 due in month three, at which point it is closer to six. That difference is the entire value of the measure.
Recompute it whenever a commitment changes. It is the one number on this page that an owner should be able to say from memory.
Measures of the shape
Operating cash flow, on its own, over twelve months. A single period tells you very little because of timing. A twelve month line tells you whether the trading generates cash.
Free cash flow. Operating cash flow less what you had to spend on equipment to keep going. The judgment is in that word "had", and it is worth making explicitly: replacing a failed van is not the same as buying a second one.
Interest and principal paid, as a share of operating cash flow. How much of what the trading produces is already committed to lenders before anything else happens. This is one a lender will compute about you, and computing it yourself first is cheap. It is also the figure that decides which of the ordinary routes to business funding are open to you at all.
Measures that mislead here
- Cash at a single date.Move the date by three days across a payment run and the figure changes completely. Any measure built on one balance is a measure of when you looked.
- Cash flow described as an average month.There is no average month. Annual insurance, tax, and quarterly bills are exactly the events that empty an account, and averaging removes them.
- Comparing operating cash flow with another business.Terms, sector and how much is subcontracted all change it. The comparison that means something is with your own previous year.
- Profit used as a proxy for cash.The reason the statement exists at all, and the point made in more detail in the profit and loss statement material.
The check before any of these
Each measure above depends on the statement being right, and the statement is right when its total agrees with the movement in the bank balance over the period. That is the only mechanical check available, and it takes a minute.
Beyond that, the measures depend on cut-off. A period missing supplier invoices shows better conversion than it earned, and the correction lands in the next period. The routine that prevents it is the closing sequence in the bookkeeping foundations guide, and the entries most often missed are the payables ones described in the accounts payable overview.
