How long can you wait for customer payments until your company starts feeling cash-strapped?
WHY THE CASH CYCLE MATTERS
If you buy and sell inventory on account, then you’ll need to know how long it takes to turn that inventory into cash. That’s exactly what the cash conversion cycle will tell you. It’s your key to making sure you’re on top of your company’s cash flow.
What is the Cash Cycle?
The cash conversion cycle (CCC) – or “cash cycle” for short – follows you through the supply, sales and payment journey. Getting paid and putting cash back into the company is priority one. You’re likely used to this process:
1. Acquire inventory from a supplier
2. Store that inventory
3. Sell it to a customer on account & invoice them 30, 60 or 90 days
4. Pay your suppliers
5. Collect on your invoices.
The CCC will give you an indication of your cash liquidity position — and it can point your attention to what is helping or hurting your cash flow.
The three variables DIO (Days Inventory Outstanding), DPO (Days Payable Outstanding) and DSO (Days Sales Outstanding) can all impact your working capital. And you can take control of them to improve your cash flow. Depending on the results, you may discover immediate areas that can be improved. We’ll explore these variables in The Magic Formula section.
Rules of thumb:
The longer the CCC, the more working capital you’ll need to manage your operations. The shorter the CCC, the more manageable your cash flow. Most companies want to shorten their CCC.
Sneak peek:
Days Inventory Outstanding – Days Payable Outstanding + Days Sales Outstanding = Cash Conversion Cycle
CCC = DIO (Days Inventory Outstanding) – DPO (Days Payable Outstanding) + DSO (Days Sales Outstanding)
WHY DOES CASH FLOW MATTER?
The CCC is a critical financial indicator of your company’s cash flow.
It shows your ability to maintain highly liquid assets and is a metric that lenders or finance and capital providers will use to assess your potential risk level.
As a business owner or operator, you must know when you’ll have access to working capital. That cash flow is important to:
Pay your staff
Order supplies and inventory
Fulfill customer orders
Take advantage of opportunities
Secure outside investment in your company
Whether you’re a new startup, a growing business or a well- established enterprise, there will come a time where capital will be an issue. Get ahead of that problem and forecast your CCC to avoid detrimental outcomes.
THE MAGIC FORMULA
How to calculate the Cash Conversion Cycle
There are three numbers you’ll need to determine your CCC, all of which you or your accounting team can pull from your financial statements.
CCC = DIO – DPO + DSO
Tell me in plain English!
The cash cycle is equal to the number of days it takes to sell your inventory (DIO), minus the days it takes you to pay your vendors (DPO), plus the days you need to collect on your invoices (DSO).
DIO: Days Inventory Outstanding
The number of days on average that your company turns your inventory into sales.
The smaller this number, the better.
DPO: Days Payable Outstanding
The number of days it takes you to pay your accounts payable.The higher this number, the longer you can hold onto cash, so a longer DPO is better.
DSO: Days Sales Outstanding
The number of days you’ll need to collect on the sales of that inventory after the sale has been made. Again, the lower the number, the better.
Example of cash flow: KEISHA
Keisha runs an industrial supply company and always pays her supplier within 30 days. She keeps enough inventory on hand to satisfy 60 days of sales and is good at managing this.
It will take 52 days on average for her customers to pay their invoices. This would be her CCC formula:
CCC = 60 days – 30 days + 52 daysCCC = 82 days
Keisha will need on average 82 days of working capital to convert purchased inventory into cash.
This is a simplified example, and to get the most accurate results you should track your DIO, DPO and DSO on a monthly, quarterly or annual basis, along with the dollar values for inventory and sales.
HOW DO I SHORTEN MY CCC?
To shorten the CCC you need to find a way of adjusting the three variables – your DIO, DPO and DSO. You have options:
1. Improve sales times
If your sales team can speed up the time to make deals, you’ll be shortening your DIO – the time it takes to turn your inventory into sales. Sell faster – it’s every company’s goal, but often easier said than done.
2. Enhance supplier relationships
Likewise, improving your supply chain can create efficiencies in your DIO. By developing good relationships with suppliers you can take advantage of just-in-time inventory practices, where your goods arrive only as needed. This may already be a common option for some industries, like manufacturing and perishables, but it is also becoming more popular in retail with the rise in drop shipping, where companies never handle their own inventory – instead, when your customer orders arrive you’ll purchase the inventory from a third party who ships directly to the end customer on your behalf.
3. Better credit and collection process
There’s no doubt that an effective collections department will improve your ability to collect customer invoices on time. Effective collections can help create a more stable and reliable DSO. However, this requires staff training, likely more personnel hours (translating into payroll costs) and leadership’s time to make sure this process is effectively managed.
4. Ask for extended payment terms
Extending your accounts payable will increase your DPO, and help offset the other two factors of your CCC. But this could negatively impact your relationships with suppliers if you extend too much, and breaching the terms could put you at risk of becoming the delinquent account you’re trying to avoid in your own A/R.
5. Reduce your 30/60/90 day payment terms
Fortunately, you’re in control of your accounts receivable terms and can shorten them to receive payment earlier. By reducing your terms, you lower your DSO and speed up your cash cycle.
Unfortunately, many customers request and expect longer terms. Some industries abide by certain timeframes to pay, which may not match up with your cash flow needs. And other customers will be delinquent on payment no matter what terms you agree upon. You may risk losing sales to competitors offering better terms.
6. Early pay discounts
These are generally not very effective at reducing your DSO and some customers take the discount even when they pay on normal schedules. Overall, this can lead to lower revenue than expected, which doesn’t amount to a cheap option.
7. Smart & strategic financing
Being strategic with your billing and collections is one of the most accessible ways to improve your cash cycle, and you can use commercial finance solutions to dramatically shorten your DSO. In fact, instead of having a DSO of 30/60/90 or more days, you can have a DSO of one day.
Content by Liquid Capital Financial Services.
If you want to know more about the different financial solutions that can improve your cashflow, please visit https://www.asteriinternational.com/financial-services or simply click on Financial Services above. You can also contact me directly for a free confidential consultation.
Liliana Rizopulos
+1 647 330 0331