Ever heard of the phrase “Cash is King?” By improving your Cash Conversion Cycle, you can ensure your business has enough money when you need it most.

CCC: What is it?

The Cash Conversion Cycle (“CCC”) is an important metric used to determine the number of days it takes a company to convert cash outflows (purchase of inventory, manufacturing expenses, etc.) into cash inflows (collections of receivables).  The longer a company’s CCC, the more working capital it will need to fund operations.  This metric is especially important when a company is evaluating the working capital needed to fund expansions, new projects, or growth.

How is it measured?

There are three components of the CCC. They include Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO), and Days Payable Outstanding (DPO).  The formulas for determining these are below:

  • DIO = (Average Inventory on Hand / Cost of Goods Sold) X Days in the Period*
  • DSO = (Average Accounts Receivable / Revenue) X Days in the Period
  • DPO = (Average Accounts Payable / Cost of Goods Sold) X Days in the Period

*Days in the Period are determined by what information you are using to do your calculation.  For example, if you were measuring your CCC using numbers that reflected an entire year, the period would be 365 days.  If you were measuring just a month, the period would be 30 days.

Once you have determined your DIO, DSO, and DPO, the formula for your CCC is: CCC = DIO + DSO – DPO

Example

Below is an example of the calculation for the CCC of a mid-sized manufacturing company.

How can I improve my CCC?

Improving your CCC means improving the efficiency with which your company converts inputs into cash.  Improving your CCC also frees up working capital or cash.  Have you heard the phrase “Cash is King?” Well, the CCC is how you ensure your business has enough cash when you need it most!

Understand your current state.

What is the first thing you do when you are about to embark on a new journey?  You look at a map and figure out where you are relative to where you want to be.  You will never be able to measure progress if you do not know your starting point.

Calculate the CCC for your company using the most recent financial data and the formulas provided earlier.  This is your, “You Are Here,” marker.

Can you recall a time in your company’s history when cash was NOT tight?  What was the CCC leading up to and during that period?  How does that compare to your current CCC?  How does your CCC compare to the standards within your industry? Use the answers to these questions to guide the goal-setting process.

Identify and quantify cash levers

As you begin to establish cash conversion goals, you will discover a variety of “levers” that can influence cash flow. Some common levers are listed below.

Sales & Marketing Levers

      • EARLY PAYMENTS: Will any of your customers offer accelerated payment terms? Offer early payment discounts, as necessary.
      • DEMAND PLANNING: Can you engage with your customers planning and purchasing departments to ensure you have access to the most reliable product demand information? Structure your agreements in ways that allow you to level load your operations.
      • DISCOUNTS AND PROMOTIONS: Do you have opportunities to offer discounts or promotions on slow-moving or obsolete inventory? Are there brokers available to provide immediate cash for this inventory?  Can any of this inventory be re-purposed for other sales channels or product lines?
      • SELLING EXCESS CAPACITY: What areas of the business have excess capacity? Use this information to offer discounted pricing as needed to fill this capacity.

Supply Chain Levers

      • EXTENDED PAYMENT TERMS: Request extended payment terms from your key vendors. Remove any early-pay discount programs as applicable.
      • MATERIAL LEAD TIMES: Evaluate long-lead material items, seeking alternate sources with shorter lead times, or assist your vendors in reducing these lead times.
      • OPTIMIZE ORDER SIZES: Review your planning and ordering process to ensure you are ordering in the most economical batch sizes.
      • OPTIMIZE ORDER TRIGGERS: Establish parameters around raw material on-hand quantities to prevent excessive buildup of inventory. Set up replenishment systems, or vendor-managed inventory systems that allow you to reduce your liabilities.

Production Levers

      • PRODUCTION LEAD TIMES: What are your internal production lead times for your highest-cost items? Look for bottlenecks in the process and find ways to eliminate this buildup of inventory.
      • MINIMIZE FINISHED GOODS INVENTORY: Establish parameters around finished goods inventory, highlighting areas where completed product is sitting on your shelf for more than a few days.
      • INCREASE THROUGHPUT: Are there bottlenecks in your production process? Use this to determine where you might need to add more capacity (human or capital resources).  Find equipment that is under-utilized, working with the sales team to bring in work that can fill this capacity.

Financing Levers

      • ASSET MANAGEMENT: What assets are available that can be used as collateral?
      • NEGOTIATE ADVANCE RATES: Negotiate with your bank to find the best inventory and receivable advance rates.
      • MICRO-MANAGE COLLECTION PROCESS: Maintain proper oversight over your AR collection process to limit past due invoices that might become ineligible.

Review this list and decide which levers are most relevant to your business.  Quantify the impact of each lever to determine the potential impact on cash conversion.

Make a plan

Decide on a goal and create a path that moves you toward that goal.  As with any good plan, make sure you have identified key milestones and assigned appropriate ownership to key elements of the plan.  Each element should relate to the identified levers.

Work the levers

This is the fun part! Work through all the levers you previously identified, adjusting your plan as more information is gathered and as progress is made.  Maintain clear and consistent communication within your team ensuring all opportunities are fully explored and executed.  Document and measure your progress along the way.

Repeat

As movement is made, priorities will change and new levers will come into play.  Re-establish your current state, set new goals and repeat the process.

Conclusion

Monitoring your cash flow can often be a daunting and nebulous task.  You can use the Cash Conversion Cycle measurement as a tool to objectively monitor your company’s effectiveness in managing cash.  Using the tools and steps above can help to significantly improve the liquidity of your business and reduce future risk.

 

This post was written by:
Jeremy Cosby, Director, DWH
jcosby@dwhcorp.com | LinkedIn

 

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