Cash Conversion Cycle: A Key Cash Flow Metric
“Cash is King!” the old saying goes. Indeed, cash really is the lifeblood of any business, and the cash conversion cycle metric is one of the most helpful ways to gauge cash flow.
Without strong cash flow, companies can be in danger of running low on money needed to fund overhead and operating expenses, not to mention raw materials and inventory. Profitability is important, but it’s cash that keeps the gears of a business running smoothly. Measuring and monitoring your cash conversion cycle is necessary to make sure you have enough cash flow to keep your operations humming.
What the Cash Conversion Cycle Looks Like
In most businesses that sell products, products are bought or created and sold, invoices are issued, receivables are collected, and this cash is used to buy more inventory and raw materials, so the cycle can be repeated. Here’s a more detailed description of the cash conversion cycle for a manufacturing company:
- Cash goes out to pay for overhead, operating expenses, raw materials and inventory.
- Products are manufactured and sold to customers.
- Invoices are issued, which results in accounts receivable (AR).
- AR is collected, re-infusing the business with cash so the cycle can start again.
The cash conversion cycle is computed by adding the total number of days from the beginning of the first step to the end of the last step. It can also be computed using the following formula:
Days Sales Outstanding (DSO) + Inventory on Hand – Days Payable Outstanding (DPO) = Cash Conversion Cycle
One of the best ways to improve your cash flow is to shrink the cash conversion cycle. Doing so will result in generating more cash for your business faster. This, in turn, will reduce your need to borrow money externally (like from a bank or your family and friends) or go through additional rounds of equity financing, which will further dilute your ownership of the business.
Where to Start
Start with your accounts receivable. This is the most common cash flow bottleneck at many companies. Slow receivables collections can have a ripple effect across your entire operation, throwing a wrench in the gears of everything. For example, talk to your customers about shortening payment terms from the standard net-30 days to perhaps net-15 days. This would cut in half the number of days required to collect cash and get it plugged back into the cycle.
Another idea is to offer your customers prompt-payment discounts if they pay their invoices early. A common example is a “2-10, net 30” discount in which customers receive a two percent (2%) discount if they pay an invoice within 10 days instead of the standard 30 days. Do the math to determine if offering prompt-payment discounts makes sense for your company financially.
On the flip side of the equation, strive to manage your accounts payable so that invoices are paid as close to the due date as possible, instead of early or late. You can use Automated Clearing House (ACH) payments from your bank to schedule invoice payments on the due date. Remember: Other than the ability to earn a cash discount, you receive no benefit by paying early — doing so adds days to your cash conversion cycle and hinders your cash flow.
Also, while setting up ACH payments, talk to your bank about other treasury management products and services that can improve your cash flow. Remote deposit capture (RDC) is a good example — this service will enable you to deposit checks from your office instead of having to drive to the bank. Wholesale lockbox is another example: Customers will send invoice payments to a special post office box that’s monitored daily by the bank, which deposits them immediately.
Inventory management is another component of the cash conversion cycle that you can manage for your company’s benefit. For example, adopting just-in-time (JIT) inventory management principles will bring raw materials to your floor just when you need them, not days or weeks early. You should also be willing to cut losses on slow-moving inventory by discounting or even donating it and taking the write-off. Excess inventory is “cash on the shelf” that could be better utilized if reinvested back into the cash conversion cycle.
Without strong cash flow, your company could be in danger of running low on money needed to fund overhead and operating expenses as well as raw materials and inventory. There are many different metrics that can be used to gauge cash flow, including the cash conversion cycle. Measuring and monitoring your cash conversion cycle is one of the best ways to make sure you have enough cash flow to keep your operations humming. A project CFO or a part-time CFO can help you shrink your cash conversion cycle, which in turn will boost your cash flow.
Arthur F. Rothberg, Managing Director, CFO Edge, LLC