Many individuals who are new to the corporate world believe that profitability is everything, accepting unfavorable credit terms with customers to maximize their revenue. However, sooner or later, they run out of cash and go bankrupt.
The availability of cash is a huge factor that impacts business performance. Without it, it becomes incredibly difficult to manage your day-to-day and long-term operations. One of the most valuable metrics to measure cash availability or cash flow is the cash conversion cycle (CCC).
In this guide, you’ll learn how to manage your cash conversion cycle, but let’s first discover what the term “cash conversion cycle” means.
In simple terms, a cash conversion cycle (CCC) is an important KPI in the world of finance that represents the time it takes for a business to convert its investments, such as production or inventory, into cash.
This period should be as short as possible because if your money is tied up with accounts receivable or inventory for too long, your business can run into cash flow problems, which can adversely impact business operations, which is why cash flow is important.
When studying the cash conversion cycle, it’s important to differentiate the concept from an operating cycle. Since both metrics assess how effectively you manage cash for your business, one can easily confuse the two. Some people even use the two terms interchangeably.
The operating cycle concept is more specific than the cash conversion cycle. While the CCC represents the amount of time it takes to turn your resources into cash, the operating cycle shows the time it takes from the initial expenditure to buy the inventory to obtain payments for the sale of that inventory.
Therefore, CCC measures your cash flow management performance, whereas the operating cycle evaluates your operating efficiency. It’s true that both cycles overlap, but they’re slightly different. Also, the two metrics affect each other. For instance, a lengthy operating cycle can extend your CCC and vice versa.
How to Calculate Cash Conversion Cycle
A digital accounting service can calculate your cash conversion cycle though, if you want to do it yourself, here is the formula to calculate the cash conversion cycle:
CCC= DIO + DSO – DPO (Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding)
In the formulae above, DIO is the average number of days to convert inventory into sales. In other words, it’s the average time you hold on to your inventory before it’s sold out. The formula to calculate DIO is:
DIO (Days Inventory Outstanding) = (Average Inventory/Cost of Goods Sold) x 365
Let’s take an example to clarify the concept. Suppose ABC’s opening inventory is valued at $500 and closing inventory is valued at $2,500 for the year 2020. The cost of goods sold as of that date is $30,000. Here is how the DIO will be calculated:
DIO=( (($500+$2,500)/2)/$30,000)x 365 = 18.25
Thus, it takes the firm around 19 days to convert inventory into sales.
Moving on, DSO is the average number of days it takes a company to turn its receivables into cash. This means how quickly the business manages to collect payments from credit customers. Here is how you can calculate DSO:
DSO (Days Sales Outstanding) = (Average Accounts receivable/Total Credit Sales) x 365
If the same Company, ABC, had accounts receivables worth $5,000 at the beginning of the period and $8,000 at the end of 2020 and reported $140,000 in credit sales, here is what its DSO would be:
DSO = ((($5000 + $8000)2)/$140,000) x 365 = 16.9
This shows that the firm is able to collect payments from debtors or accounts receivables in around 17 days, on average.
The final component of the cash conversion cycle formula, DPO, is the average number of days a firm takes to pay its accounts payables. This simply indicates how long the company takes to pay its credit suppliers. The formula to calculate DPO is:
DPO = (Average Accounts Payable/Cost of Goods Sold) x 365
Again, let’s suppose the opening accounts payable for ABC Company was $600, and the closing accounts payable was $1,800 at the end of 2020. Since we already know that the cost of goods sold was $30,000, the DPO for the business will be:
DPO = ((($600 + $1800)/2)/$30,000) X 365 = 14.6
Hence, it takes the firm around 15 days to pay its suppliers in full.
Now, let’s put the pieces together to calculate the cash conversion cycle for the company.
Cash conversion cycle = 18.25 + 16.9 – 14.6 = 20.55
The CCC for the Company is 20.55. This means that it takes the firm around 21 days to convert its initial investments into cash.
Now you know how a cash conversion cycle is calculated. But what exactly does a cash conversion cycle indicate? Let’s find out.
Interpreting Cash Conversion Cycle
The shorter your cash conversion cycle, the better it is for your business. However, this doesn’t mean that a negative cash conversion cycle is desirable. Having a negative CCC has its own drawbacks. It clearly indicates that you’re either taking too long to pay your credit suppliers, not allowing reasonable credit to your customers or both.
You certainly have free cash to make additional investments, but if your existing customers are not happy with the short credit terms or your suppliers are dissatisfied with your payment schedule, you can lose them. When that happens, your profits can sharply drop. Therefore, you should do your best to shorten your cash conversion cycle but keep it positive.
The shorter your cash conversion cycle, the better it is for your business. However, this doesn’t mean that a negative cash conversion cycle is desirable. Having a negative CCC has its own drawbacks. It clearly indicates that you’re either taking too long to pay your credit suppliers or not giving your customers reasonable credit.
You certainly have free cash to make additional investments, but if your existing customers are not happy with the short credit terms or your suppliers are dissatisfied with your payment schedule, you can lose them. When that happens, your profits can sharply drop. Therefore, you should shorten your cash conversion cycle and keep it positive.
Anyhow, collecting what you’re owed is one of the biggest challenges in business. Despite the sales you make, having a large amount of uncollectible debt can slow down or even halt your business operation. Plus, chasing a payment that’s due is not only time-consuming but also expensive. If your business has a positive CCC, it indicates that you’re doing a commendable job in collecting its receivables. Perhaps you might be offering incentives or early payment discounts to encourage your clients to pay on time.
The Benefits of Having a Positive Cash Conversion Cycle
Possessing cash is important for making payments to suppliers. A positive CCC shows that although you’re paying your suppliers on time, you’re maximizing the time to transfer money. It’s quite possible that you’re great at negotiating payment due dates with suppliers. This means that you might be possessing cash for longer periods.
Besides, a positive CCC may also indicate that your business is moving inventory quickly without selling it at unreasonably low prices. In the drive to improve cash availability, you shouldn’t offer steep discounts unless it’s extremely important. Additionally, a positive CCC clearly indicates that you’re quick to adapt to customer demands and make intelligent inventory-related decisions.
Furthermore, a positive CCC makes it incredibly easy to obtain loans. When you approach lenders, they won’t just check how profitable your business is but also take into account your cash flow situation before deciding on the loan amount and interest rate. This helps them know whether you’re likely to repay the loan when it’s due. When you show a positive CCC, they’ll know that you’re able to collect most of your earnings, and thus, the chances of defaulting are low. With a positive CCC, not only are you able to acquire a good loan, but you are also in a better position to negotiate its terms.
Now that we know the importance of CCC, let’s discuss how to manage your cash conversion cycle:
How to Manage Your Cash Conversion Cycle
As with other metrics, you need to calculate your cash conversion cycle from time to time and see if it’s improving or not. To obtain a genuine picture of how any operating changes or sales are affecting your CCC, consider tracking your CCC annually and comparing the numbers from year to year. Manage your cash flow by using Fully Accountable digital cash flow experts.
If you’re not sure how to manage your cash conversion cycle, follow these tips:
Tighten Up Invoicing Procedures
The most common issue that adversely affects your cash conversion cycle is overdue customer invoices. To improve your ability to collect payments from accounts receivables, develop a plan that identifies the reasons for payment delays and possible solutions. You’ll need to go deep into invoicing methods, collection techniques, and the processes of dispute management. One great solution is to refine your invoicing procedures. The longer you take to issue invoices to customers, the more time the customer will take to make a payment.
Refining invoicing procedures could simply involve making the process more efficient or increasing the frequency at which invoices are prepared.
Segment Your Customers
Another useful tip to improve your cash conversion cycle is to prioritize customers by risk profile, size, and importance and then execute proactive payment collection activities. If a supplier consistently delays payments, your credit financial controller team should start sending reminders before the payment is due and conduct strict follow-ups to minimize delays. Also, establish clearly defined roles for customer service, credit control, and sales to speed up issue resolution processes.
Set Inventory Service Levels for Customers
You can’t just go on to reduce the amount of inventory you acquire every month to improve your cash conversion cycle. It’s important to consider the potential impact it can have on your ability to fulfill orders. Otherwise, you can lose customers and experience a decline in sales. Your aim should be to stop managing uniform inventory levels for all customers because it leads to unnecessarily high stock levels.
Your products’ contribution to sales, analysis of customers, and profit and payment performance should all be taken into account when optimizing inventory. This should help you set certain service levels for inventory and eliminate uniform service levels. The service level to your top customers or those paying on time shouldn’t be the same as those that consistently pay late. This should help reduce inventory in an intelligent way, thereby improving your cash conversion cycle.
Monitor Supplier Lead Times
If some of your suppliers don’t fulfill orders on time or in full, you might be forced to maintain a safety stock that can hurt your cash conversion cycle. One effective solution for this is to start monitoring supplier performances, especially their lead times. Assessing and negotiating lead times should ensure that inventory is received on time. Hence, you won’t have to manage safety stock.
Ordering smaller, more frequent supplies should also help reduce stock pile-ups. Depending on your relationship with suppliers, you may even negotiate to reduce the minimum order quantity (MOQ).
Extend Payment Terms
If your cash conversion cycle is too high, you may consider negotiating with your suppliers to extend payment terms. This will depend on how well you’ve managed your relationship with suppliers and, of course, your negotiating ability.
However, don’t resort to delayed payments when they’re due. This can hurt your suppliers’ cash flow and eventually disrupt the supply chain. It can even undermine your position in negotiating prices and hurt supplier relationships.
Make Payments When They’re Due
Inexperienced businesses believe it’s great to pay suppliers as soon as possible. However, they don’t realize that doing so leaves behind less cash to pay for the day-to-day operations. Just as you shouldn’t delay payments when they’re due, you should not make payments until they’re due. Review your supplier contract and make sure that it details the updated payment terms accurately. Then, ensure payments aren’t made earlier than the agreed-upon time.
You may also review the frequency of payments to suppliers and adjust them to weekly or monthly payment runs. This should also help manage your cash conversion cycle more efficiently.
This was our take on how to manage your cash conversion cycle. If you’re facing cash flow issues, following the above-discussed techniques should help make your cash flow situation better.
Furthermore, accounting for cash flows is just as important as managing a cash conversion cycle. Whether you need to know how to calculate your cash conversion cycle, create a balance sheet, or figure out which accounting software to use, Fully Accountable can help you. If you’re looking for an outsource financial agency, digital accountants, or fractional CFOs, contact Fully Accountable today or schedule a 30-minute strategy call.