FREE online courses on How to Manage Cash Flow - Chapter 4 - Warning Signs

 

One important element in cash flow management is to fully understand the warning signs of cash flow distress. Some early warning signs include:

 

·         Cash balances are low compared to historical balances.

·         Inventory is not moving.

·         Vendor payments are made late.

·         Banks are requesting financial statements.

·         Major purchases have to be postponed.

·         Management has become very risk adverse; i.e. overly cautious about spending money.

 

One way to monitor cash flow is to track liquidity ratios and compare these ratios to historical ratios and/or industry averages. Some examples include:

 

Current Ratio = Current Assets / Current Liabilities

Acid Test = Cash + Accounts Receivable + Marketable Securities / Current Liabilities

Cash Flow to Debt Ratio = Cash Flow / Total Debt

Cash Flow to Income Ratio = Operating Cash Flow / Net Income

 

Another warning sign is an unfavorable Z Score. The Z Score is about 90% accurate in predicting bankruptcy in the first year and about 80% accurate the second year. The Z Score combines five ratios and compares the result to a scoring scale. A weight is assigned to each ratio. The Z Score is calculated as follows:

 

 Z = 1.2 (A) + 1.4 (B) + 3.3 (C) + .6 (D) + .999 (E)

 

A: working capital / total assets

B: retained earnings / total assets

C: earnings before interest taxes / total assets

D: market value of equities / book value of debt

E: sales / total assets

 

The scoring scale for the Z Score is:

 

If the Z Score is 1.8 or less, there is a very high probability of bankruptcy.

If the Z Score is 1.81 to 2.99, we are not sure about bankruptcy.

If the Z Score is 3.0 or higher, bankruptcy is unlikely.

 

Example 15 - Calculate the Z Score

 

Assume we have account balances of:

 

Total Assets = $ 1,000,       Retained Earnings = $ 400, Sales = $ 1,500,

Earnings Before Interest & Taxes (EBIT) = $ 50, Working Capital = $ 100,

Market Value of Stock = $ 600, Book Value of Debt = $ 700

 

1.2 x ($100 / $1,000) = .120                   1.4 x ($400 / $1,000) = .560

3.3 x ($ 50 / $ 1,000) = .165                   .6 x ($600 / $700) = .514

.999 x ($1,500 / $1,000) = 1.499

 

Z Score = 2.86 (.120 + .560 + .165 + .514 + 1.499)