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Master the Cash Conversion Cycle

Without cash, businesses die.

The single best number to measure to ensure a healthy cashflow is the Cash Conversion Cycle (CCC).

In this article we're going to show you:

  • Why it's important

  • How to measure it

  • How to improve it

a man trying to capture flying cash with a butterfly net

What is the Cash Conversion Cycle?

The cash conversion cycle measures the time it takes for a company to convert its investment in Working Capital cash from sales.

Simply put: it is the number of days between paying suppliers and receiving payments from customers.

The shorter you can make your cash conversion cycle, the quicker you will have cash in the bank!

Calculating the Cash Conversion Cycle

The cash conversion cycle consists of three main components:

1. Days Inventory Outstanding (DIO): The average number of days a company's inventory is held before it is sold.

2. Days Sales Outstanding (DSO): The average number of days it takes for a company to collect payment after a sale.

3. Days Payable Outstanding (DPO): The average number of days a company takes to pay its suppliers or creditors.

And here's how you use them:

Cash Conversion Cycle:

Days Inventory Outstanding (DIO)

+ Days Sales Outstanding (DSO)

- Days Payable Outstanding (DPO)

To calculate each component, you'll need to refer to your company's financial statements and perform the following calculations:

Days Inventory Outstanding (DIO): DIO = (Average Inventory / Cost of Goods Sold) x 365 days

Days Sales Outstanding (DSO): DSO = (Average Accounts Receivable / Total Credit Sales) x 365 days

Days Payable Outstanding (DPO): DPO = (Average Accounts Payable / Cost of Goods Sold) x 365 days

Let's illustrate with a practical example - here are the relevant figures for Tommy's Toasters. Tommy buys toasters, holds them in inventory, and sells them on credit to his customers:

- Average Inventory (start & end of the 12m period): $1,000,000

- Cost of Goods Sold: $5,000,000

- Average Accounts Receivable: $800,000

- Total Credit Sales: $6,000,000

- Average Accounts Payable: $400,000

Using the formulas above, we can calculate the cash conversion cycle:

DIO = ($1,000,000 / $5,000,000) x 365 days = 73 days

DSO = ($800,000 / $6,000,000) x 365 days = 49 days

DPO = ($400,000 / $5,000,000) x 365 days = 29 days

Cash Conversion Cycle = DIO + DSO - DPO

= 73 days + 49 days - 29 days

= 93 days

So it takes Tommy 93 days from purchasing his inventory to converting it to cash in his bank account ... but is that good enough?

93 days is a long time to park your cash and wait for it to generate a return - that's three months! If Tommy could reduce his cash conversion cycle by a whole month, he'd have more cash to invest in growing his business.

Strategies to Improve the Cash Conversion Cycle

While a shorter cash conversion cycle is generally desirable, the optimal cycle length can vary depending on the industry, business model, and specific circumstances of a company. However, there are several strategies that businesses can implement to improve their cash conversion cycle and enhance their cash flow management:

1. Inventory Management Techniques:

- Implement just-in-time inventory practices to reduce excess stock levels.

- Leverage demand forecasting tools to optimise inventory levels based on sales projections.

- Consider vendor-managed inventory or consignment agreements to shift inventory ownership and costs to suppliers.

2. Accounts Receivable Management:

- Offer discounts or incentives for early payments to encourage prompt collection of accounts receivable.

- Automate invoicing processes and follow up on overdue payments promptly.

- Consider factoring or supply chain financing solutions to accelerate cash collection.

3. Accounts Payable Management:

- Negotiate longer payment terms with suppliers to increase the days payable outstanding (DPO).

- Implement a centralised accounts payable process to ensure timely and accurate payments.

- Explore dynamic discounting or reverse factoring programs to optimise cash outflows.

Think it can't be done in your business?

Everybody knows the worst phrase to hear in a business is "We've always done it this way".

But most people forget the second worst phrase: "It can't be done".

If you think you can't improve your business's cash conversion cycle, check out these examples of businesses that manage very, very large amounts of inventory and have improved their cash conversion cycles to exceptional levels:

Famous Cash Conversion Cycles

Woolworths (Australia): negative 18 days

What does a negative cash conversion cycle mean?

You're getting paid for sales before you need to pay your suppliers.

So even if your team thinks "it can't be done", remember that it can. You might not get to Amazon levels, but every day's reduction in your cash conversion cycle is an extra day of cash in your bank account.

It's worth the effort.


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