The Cash Management Gauge

The Cash Management gauge score depends on the current and past values for the following ratios:

• Current Ratio
• LTD/Equity
• Debt/CFO
• Inventory/CGS
• Finished Goods/Inventory
• Days of Sales Outstanding
• Working Capital/Invested Capital
• Cash Conversion Cycle Time
  

We've defined these ratios earlier.  Most of the data required to compute these values are drawn from the Balance Sheet, but some figures from the Income Statement and the Cash Flow Statement are also used.

The Cash Management gauge is determined by calculating a score for each of the eight items listed above.  A weighted average of the scores is scaled to set its minimum value at zero and its maximum value at 25 points.

We're tough graders: it's a rare company that will achieve a 25-point Cash Management score.

The scoring details are described below.  Please note there is an overriding zero-point floor and a five-point ceiling for each ratio.


Current Ratio

Score = 5 - 2.5 * (Current Ratio - 2.5) ^ 2

In our sample Balance Sheet, GCFR Corp. had a Current Ratio was 75/41 = 1.83.  It would earn 3.9 points.

The maximum score of 5 is attained when the Current Ratio = 2.5.  Points are deducted for higher Current Ratios, which might seem strange, because the company is building its bank account instead of putting its assets to work.

LTD/Equity

Score = 5.0 - 20*(LTD/Equity -0.2)^2

In our sample Balance Sheet, GCFR Corp. had an LTD-to-Equity ratio of 60/134 = 44.8 percent.  It would earn 3.8 points.

The maximum score of 5 is attained when Long Term Debt to Equity equals 20 percent.  The equation is constructed such that a company with an LTD/Equity ratio between 0 and 40 percent will get at least 4 out of the 5 possible points.  We think some debt is good because it gives stockholders leverage, but we disapprove of excessive debt.

Debt/CFO

Score = (-1.5) * Debt/CFO + 5.25

Debt/CFO is measured in years.

A bonus point is awarded if Debt/CFO is lower that it was one year earlier.

In our sample Balance Sheet, GCFR Corp. had a Debt-to-CFO ratio of 16.6 months = 1.38 years.  It would earn 3.2 points.

Inventory/CGS

Score = 25 * (delta Inventory-to-CGS / Inventory-to-CGS one year earlier)

Inventory-to-CGS is measured in days.

A 20 percent (i.e., 0.2) reduction in the number of Inventory days will achieve the full five points (25 * 0.2).

In our sample Balance Sheet, GCFR Corp. had a Inventory/CGS ratio = $13/0.433 = 30 days.  It the ratio was 33 days one-year earlier,  then the percent reduction would 3/33 = 0.091.  It would earn 2.8 points.

We don't use this ratio if inventory isn't significant for the company (e.g., the company sells a service, not a product).

Finished Goods/Inventory

Score = 200 * (decrease in the Finished Goods ratio from its median value)

If the current percentage of inventory made up of finished goods is above this ratio's median value, no points are earned.

A company gets the full 5 points if the current value of the finished good ratio is 2.5 or more percent less than its median value.

We don't use this ratio for scoring if the company's inventory doesn't consist of varying mix of raw materials, work in process, and finished goods (e.g., the company is a retailer), or if inventory isn't significant for the company (e.g., the company sells a service, not a product).

For example, let's say the finished goods component of inventory (the rest being raw materials and work in process) is now 28 percent and that the median value for this ratio is 30 percent.  The 2-percent reduction, worth 4 points, suggests that the company's sales were greater than expected.  The opposite, an increase in finished good inventory, is worrisome.

Days of Sales Outstanding

Score = 25 * (delta DSO / DSO one year earlier)

A 20 percent (i.e., 0.2) reduction in DSO is needed to earn the full five points (25 * 0.2). Lesser reductions will get lower scores. The score will be zero if there is no reduction.

For example, if GCFR Corp.'s Balance Sheet shows that Accounts Receivable averaged $12 million over the last year, and if its Revenue during the year was $200 million, then Receivables were 0.06 of annual Revenues, which is 21.9 days of Revenue.  If last year's figure was 23.9 days, then the score would be 25 * (2/23.9) = 2.1 points.

Working Capital/Invested Capital

Score = 100 * (Working Cap ratio - Working Cap ratio on year earlier)

In other words, each percent increase in Working Capital relative to Invested Capital earns another score point.  The maximum score would be earned with a 5 percent or greater increase in Working Capital to Invested Capital.

In our sample Balance Sheet, GCFR Corp. had a ratio of Working Capital to Invested Capital of 34/182 = 18.7 percent.  If the ratio had been 17.0 percent one year earlier, then the score would be 1.7 points.

Cash Conversion Cycle Time

Score = (1/2) * (percent decrease in CCCT from last year)

No score is allowed to be less than zero or greater than five.

In other words, each two percent decrease in CCCT earns another score point.

In our sample Balance Sheet, GCFR Corp. had a CCCT of 37 days.  If  this parameter had been 40 days one year earlier, then it decreased by 3/40 = .075 (7.5 percent).  This would earn 7.5/2 = 3.75 points.

Determining the Cash Management Score

We don't simply add up the scores described above to calculate the Cash Management score.  We believe some ratios are more significant than others.  To be specific, we use the following weights:

• Current Ratio (20)
• LTD/Equity (5)
• Debt/CFO (5)
• Inventory/CGS (20)
• Finished Goods/Inventory (20)
• Days of Sales Outstanding (5)
• Working Capital/Invested Capital (10)
• Cash Conversion Cycle Time (15)
  

The Cash Management score is 5 * (the sum of each ratio's score multiplied by its weight) / (100, the total of the weights).




This post was last modified on 24 June 2009