The Cash Conversion Cycle is, basically, how long it takes to see cash in your bank account from the day a sale is made until your vendors are paid. What’s left is sitting in your bank account after is the conversion of the sale to cash.
The formula for the Cash Conversion Cycle is:
For instance:
In a previous post, we talked about how, in order to increase your cash flow, you want to decrease your Days Sales Outstanding (DSO). This is the amount of time it takes between when an item is sold and when cash is received from the customer. In many retail and service environments, this is the same day. But there are other retail and service businesses that collect after a job is complete which could be a month or more after the initial sale or on an ongoing basis such as with an investment or rental/lease businesses. The bottom line is your company will be out of cash until you make a sale and collect those funds.
We also talked about how decreasing Days Inventory Outstanding (DIO) would increase cash flow. DIO is how long it takes from the purchase of inventory until it goes out the door to a customer. If your cash is tied up in inventory, it will not be readily available for use by the business. We mentioned there is a sweet spot of having enough inventory on-hand to cover sales but not maintaining too much inventory that it sits on the shelf or in a warehouse somewhere tying up your cash in non-liquid assets. It is the “not maintaining too much inventory” that is the inspiration behind decreasing the DIO to decrease the Cash Conversion Cycle and increase cash flow.
And then there is Days Payable Outstanding (DPO). This is how long you have before a bill comes due and cash goes out of your account to pay for inventory or services purchased, decreasing cash flow. In general, you want to increase this number, though an unfortunate truth of business is that you can’t put off paying a bill forever. It eventually must be paid.
The biggest tip for maintaining your cash conversion cycle is to get the final number as low as is prudently possible. Why “as low as prudently possible”? Why not get the number to zero? There are several reasons zero may not be the ideal number or simply may not be possible. As mentioned, in some industries, cash does not come in until a job is done. This means a natural and expected delay in DSO. And while we would all like to believe that jobs will be done exactly when expected, we also know that is often not the case. Delays happen which will extend DSO even further.
In addition, some banks may put delays on processing electronic funds based on a variety of factors including the size of your business, and factors that may be out of your control because they involve the customer. And then there are cash and checks. Yes, even in today’s electronic world, some people do still use checks and paper money. This means that funds have to be manually deposited in a bank, adding time to the DSO.
Another possible factor is that some vendors will give a discount for bills paid promptly, regularly, or even early. Or, conversely, if a bill stands too long, a late fee or interest might be charged. In cases such as these, it does not benefit the business or cash flow to try to push out the DPO as long as possible for the sake of the conversion cycle.
Still confused? Let's look at another example:
As you can see, the Cash Conversion Cycle in this example is at a negative (-) 18. This may seem ideal, after all if zero (0) is the goal, a negative should be even better, right? Are there scenarios in which this negative cycle is a bad thing? It is possible that the owner of the business will see the cash in the account as “extra” cash. After all, the vender is paid, right? Often, when we see extra cash, we assume that it is free to spend, either on a one-time purchase or by increasing our budget. This could be a peculiarity of this particular cash flow cycle. It could also be that inventory is out or running low and what seems like “extra” cash needs to be spent to increase stock for future sales.
An interesting point brought up by this example is that it's not always just about the numbers. As a business owner, you need to know yourself and your tendencies as well as you know your business.
Let's look at one more example:
There are a few potential causes for the long conversion cycle as well as a few ways this might be easily remedied.
The DSO is 60 days. It’s possible that this number is unusually high because there wasn’t enough inventory in stock and items were on backorder. Even with the relatively low DIO, it’s possible on-demand items will be sold out. This is a good problem to have, at least initially. But eventually, you want to know your inventory demand well enough to be able to anticipate high-demand items and when the best time would be to purchase them. This would allow for decreasing both DSO and DIO.
In this example, the DPO is disproportionately low. It is good to pay off bills. Some business owners get nervous about having outstanding bills, so they take out a loan to pay off the bill, knowing that cash is incoming. If the quick turnaround to pay off vendors leads the business owner to take out a loan, then this could cause future problems and decrease cash flow in the future. In addition, if it is known that inventory tends to sit for some time, it might be beneficial for the business owner to discuss the possibility of opening a line of credit that is 60-days same as cash, especially for vendors who do not give credit for early payoff or who require payment up front. Vendors get paid, but the DPO gets pushed out, lowering the Cash Conversion Cycle to the benefit of the business.
Ultimately, it is up to you, the business owner, to determine what is most important to you. Would you prefer a “zero cycle” or saving money with a discount or lower interest rate? Are you able to get cash up front for your inventory or services rendered, or does it work better for both you and your customer to save payment until service is complete or inventory is in-hand? Neither is wrong. Some business owners don’t like having debt. Others prefer to save money by pushout out payment. Some customers expect to pay immediately, in other industries, there is an expectation that payment comes later. As the owner, you know your business and customers better than anyone. And what works now may even change over time. There could even be seasonal/circumstantial reasons for changing the approach you take in regard to minimizing the cash conversion cycle.
If you are wondering about the best approach to take for your business, or you're not sure how to evaluate your business, especially in light of your personal goals and values, RSQ Advisors would love the opportunity to come alongside you and guide you onto a path that works best for you and your business. Contact us for a free consultation.
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