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Why understanding your business' Cash Conversion Cycle is essential

Find out what the Cash Conversion Cycle is, and why it’s so relevant for every business owner.

The Cash Conversion Cycle (CCC), also known as the Net Operating Cycle, is a critical metric for businesses of all shapes and sizes. It represents the time between paying for inventory and receiving cash from sales, and the shorter this period is, the sooner a business can reinvest that cash into the next round of sales.

Thoroughly understanding your business' Cash Conversion Cycle by breaking it down into its components will help identify the source of any cash flow pressure and guide you on the actions needed to improve the health of your business.

Understanding the Cash Conversion Cycle

It should be the goal of every business to have a short Cash Conversion Cycle as it indicates that your business is using its working capital efficiently to generate sales. Put another way, the less time between actually paying for your goods and receiving cash from your customers, the sooner you can reinvest that money into making more sales and covering operational costs. 

For most businesses, especially those where inventory represents a large part of Cost of Goods Sold, there are three important phases in generating cash profits.

  1. Buying inventory (which could be paid for upfront or payable on credit terms)
  2. Holding the inventory while its turned into product that can be sold
  3. Selling the final product (which might be for cash up front, or more likely on credit terms)

The CCC quantifies the time taken at each of these steps, and returns the average the number of days from when the business outlays cash to purchase inventory, to when it receives cash from the sale of the finished goods. 

The CCC is calculated as:

CCC (Cash Conversion Cycle) = DIO (Days Inventory Outstanding) + DSO (Days of Sales Outstanding) – DPO (Days Payable Outstanding)

Let’s step through each of the components.

Days of Inventory Outstanding (DIO)

Days of Inventory Outstanding is the average number of days it takes for a business to sell its inventory. A lower number is better, and means that the business is able to move its inventory quickly, accelerating the time it takes to receive cash that can be reinvested again. 

It is calculated as:

DIO = (Cost of Average Inventory / Cost of Goods Sold) x (Number of days in Accounting Period)

For example, if a business had average inventory of $50 over a year, and COGS (Cost of Goods Sold) of $800 for that year, then DIO = $50 / $800 * 365 = 22.8 days, which means that it takes the business an average of 22.8 days to sell its inventory.

The sooner a business can turn it's inventory into sales, the sooner it can receive cash but rarely is cash received at the time of sale as we'll see below. 

Days of Sales Outstanding (DSO)

Days of Sales Outstanding is the average number of days it takes a business to collect its accounts receivable. A lower number indicates that a business’ customers are paying their invoices quickly, allowing a business to reuse the cash sooner. 

It is calculated as:

DSO = (Average Accounts Receivable / Total Credit Sales) x (Number of Days in Accounting Period)

For example, if a business had average accounts receivable of $25 over a year and Revenue of $250 for that year, then DSO = $25 / $250 * 365 = 36.5 days, which means that it takes the customers an average of 36.5 days to pay their invoices.

Long payment terms and slow-paying customers lead to extended Days Sales Outstanding periods and can put enormous pressure on the cash flow of small businesses. In our 'Managing your accounts receivable in 2021' Part 1 and Part 2, we look at some useful strategies to get your invoices paid early so your business can minimise that cash flow stress.

Even businesses with the most diligent receivables management processes sometimes need help to bring forward cash flow from unpaid invoices which is where invoice financing can be a useful tool. Also known as debtor financing, it enables businesses to access up to 80% of the value of outstanding invoices upfront which has the effect of shortening the Days of Sales Outstanding period. This cash can then be used to invest in more inventory, new equipment or pay operational costs, and when the customer invoice is eventually paid, the finance is repaid and the balance is returned to the business. 

Days of Payables Outstanding (DPO)

Days of Payables Outstanding shows the average number of days it takes a business to pay its accounts payable. A longer DPO is beneficial as it allows the business to hold on to cash for longer, allowing it to be used within the business before leaving the coffers. Taking a longer time to pay invoices will increase your DPO, and therefore shorten your Cash Conversion Cycle (aka Net Operating Cycle).

The calculation is:

DPO = (Accounts Payable / Cost of Goods Sold in Accounting Period) x (Number of Days in Accounting Period)

For example, if a business had average accounts payable of $100 over one year, and COGS of $800 for that year, then DPO = $100 / $800 * 365 = 45.6 days, meaning that the business repays its invoices after 45.6 days on average.

Although it sounds tempting to take your time paying for inventory to extend your DPO and shorten CCC, it can put pressure on your supplier relationships as it will have the direct effect of extending their Days Sales Outstanding. An alternative is to use trade financing which allows businesses to pay suppliers upfront, often to take advantage of early payment discounts, without eating into working capital. The trade finance can then be repaid when the customer invoices are paid and is an effective tool to shorten the cash flow gap associated with a long Cash Conversion Cycle.

Putting the Cash Conversion Cycle back together

Bringing together the components of our example business, it has a Days Inventory Outstanding of 22.8 days, Days Sales Outstanding of 36.5 and a Days Payable Outstanding of 45.6 days. Combined, this represents a Cash Conversion Cycle of 13.7 days meaning that there is an average of 13.7 days between paying for inventory and receiving cash from sales.

Given the importance of the Cash Conversion Cycle and what it means for the cash flow of businesses, it should be tracked over time to identify trends and broken into its components to properly understand the drivers. As we have shown, there are some levers that can be pulled to improve each element of the CCC to improve working capital efficiency.

If, despite your best efforts you still have a cash flow gap to close, and you would like to learn more about our invoice financing and trade financing services, please visit us at earlypay.com.au or speak to your Broker or BDM.

 

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