Many companies recognize that one of the easiest and fastest ways to boost cash available for their use is to collect accounts receivable more quickly. However, the cash conversion cycle contains other critical components as well. It is important to consider both uses and sources of cash when implementing a sound cash management strategy. There are several key performance indicators to examine when trying to tighten the cash conversion cycle and boost cash available for use: inventory turnover, accounts receivable (AR) turnover, and accounts payable (AP) turnover.
The cash conversion cycle is a simple formula – it is calculated as such: (days inventory outstanding + days sales outstanding) – days payables outstanding. An example, your company collects AR on average every 43 days, it replenishes inventory every 50 days, and pays AP on average every 28 days. Your company completes the cash cycle every 65 days [(43 + 50) – 28]. Is this number good? Understanding the components to this formula can unlock opportunities to improve your company’s cash flow cycle.
Inventory is converted to AR which is then collected as cash. Cash is then used to purchase inventory and the cycle repeats.
First, when evaluating the inventory component of the cash cycle, consider your inventory processes and systems. Is there an opportunity to enable more efficient processes? Can you make investments in more effective inventory systems? Does your company have adequate inventory quantities or is there excess inventory? Does your supply chain need to be reconsidered? If inventory is over-stocked, slow-moving, or if there is a high level of inventory obsolescence, this results in an undesirable lengthening of the cash conversion cycle.
Next, evaluating the AR portion of the cash cycle, consider your company’s accounts receivable policies. Are there operational opportunities for shrinking the length of the cash conversion cycle? Policy examples include: Are customer credit terms appropriate? Are new customers subjected to an adequate credit check? Are discounts offered for cash payment or payment within 10 days? Could credit card payments be accepted for small invoices? Are statements sent regularly? And finally, is there adequate follow-up, and a halt of further sales, to past due customers? Addressing these questions is a most effective way to immediately shrink the cash conversion cycle.
Lastly, when examining accounts payable in regards to the cash cycle there may be opportunities to change AP policies. Most businesses strive to pay their bills timely but may not consider opportunities to lengthen the accounts payable cycle, thus freeing cash for other uses. For example, are there vendors from whom your significant volume of business may allow you to obtain more favorable, extended payment terms? Are there discounts being missed or that could be negotiated with vendors to whom you make prompt payments?
Attention to each component of the cash conversion cycle is beneficial in shortening its overall length, thereby reducing the need for borrowing or factoring receivables as well as the associated fees and costs of meeting short-term liquidity needs. Cash is then freed up to be re-invested in the company or for owner benefits.
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