It takes money to make money. All businessmen know that. The most fundamental explanation is the Cash Cycle or the Cash Conversion Cycle. When thinking about your company, understanding how quickly you turn cash outflows into cash inflows is as important as how much profit you are booking. This is one of the first metrics I check when I’m hunting for understanding of a business. Today, we’ll see how it applies to a manufacturer I looked at the other day and a distributor that is one of our clients.

Let’s break this down We measure how swiftly a company turns cash into goods or services and back into cash. To do this, compute the cash conversion cycle, or CCC.

CCC = DIO + DSO – DPO   where:

DIO = days inventory outstanding

DSO = days sales outstanding

DPO = days payable outstanding

DIO = 365*Average Inventory/COGS. Days inventory outstanding is how many days it takes to sell inventory. Shorter is better. The more quickly a company can sell its inventory, the less time that cash is tied up as inventory sitting in the warehouse.

DSO = 365*Average Accounts Receivables/Revenue.  Days sales outstanding is how many days it takes to collect accounts receivable. Shorter is better. Quickly collecting the cash for sales means more quickly putting that cash back to work rather than lending it out to its customers (at 0% interest).

DPO = 365*Average Accounts Payable/COGS.  Days payables outstanding is how many days it takes the company to pay the bills to its suppliers. Longer is better. That is, extending payment of accounts payable acts as an interest-free loan to the company and keeps more cash within the company – until they quit extending terms.

Why does the CCC matter? The less time it takes a firm to convert outgoing cash into incoming cash, the less cash you need to run the profit engine. The less money tied up in inventory and accounts receivable, the more available to grow the company, pay investors, or both. To calculate the cash conversion cycle, add ‘days inventory outstanding’ to ‘days sales outstanding’, then subtract ‘days payable outstanding’. Like golf, the lower your score here, the better.

Example: a small distributor

Cash Conversion Cycle
Period 1 Period 2 Period 3
DIO 1.04 0.00 0.00
DSO 51.27 67.19 33.57
DPO 57.09 64.53 33.52
CCC -4.78 2.66 0.04

You can see that, as with most distributors, their cash cycle is balanced as they negotiate terms with their suppliers that let them pay for goods about the time they are able to collect on sales. They’ve pretty much averaged zero days cash conversion over these three periods. In that way they avoid needing large amounts of cash to support their profit engine.

For most small businesses, the CCC can give you valuable insight into how much cash is needed to sustain the business, where it is coming from, and whether or not that is a suitable place. It will also tell you how long it takes to turn a profit into cash. A company that’s taking longer to make cash will need to tap financing to grow faster than its profit reinvestment allows.

Many companies have poor basic capital structures where there is no real source of financing for the needed cash to operate the business, and this needs to be corrected.

Example: a small manufacturer

Cash Conversion Cycle
Period 1 Period 2 Period 3
DIO 299.10 375.04 525.18
DSO 175.03 33.17 24.72
DPO 171.76 210.53 312.80
CCC 302.38 197.68 237.10

This firm needs to do work on its policies and operations. Its position improved somewhat over the three time periods, but it still needs to have 237 times its average daily revenue in cash to finance its operation! Mostly this is due to excessively large inventories that are being financed on the back of paying its suppliers very slowly – almost a year on average! – and collecting from its clients very quickly. One look at this would lead us to go look at the inventory to see if it is still useful or if they’ve accumulated a bunch of inventory that will have to be thrown away.

For other firms, especially firms under duress, the CCC can tell you how well the company is managed or, at least, the degree of distress. Firms that begin to lose control of the CCC may be losing their clout with their suppliers (who might be demanding stricter payment terms) and customers (who might be demanding more generous terms). This is an important signal of future heightened distress — one that is key to investors and lenders.

How much capital do I need to operate my Cash Cycle?

You must have come up with the cash to pay for the inventory not when it is delivered, but when the invoice is due. Normally this is 30 days after delivery, but specific to the terms you negotiated with your supplier. Then, to the extent those terms are sooner than it turns into a sale (i.e. DIO > DPO), you need to finance your cost of inventory per day for that number of days. Additionally, you need to finance your receivables balance for the duration it is outstanding.

Where does it come from

Mostly, you’ve built this up from the original investment in the business, and accumulated profits. Conversely, you can borrow against your receivables and inventory assets (on the balance sheet) to finance them. This financing is called a working capital line of credit, or factoring.

What change over time tells me

For a firm in distress or need of capital, I’m highly interested in comparing a company’s CCC to its prior performance. Here’s where I believe all owners, managers, investors, and lenders need to become trend-watchers. Sure, there may be legitimate reasons for an increase in the CCC, but all things being equal, I want to see this number stay steady or move downward over time. Because of the seasonality in some businesses, the CCC for the TTM period may not be strictly comparable to other fiscal periods. Even the steadiest-looking businesses on an annual basis will experience some quarterly fluctuations in the CCC.

Though the CCC is easy to calculate, it’s definitely worth watching every quarter. You’ll be better informed about potential problems, and you’ll improve your odds of finding the right capital structure for your business.

If you want to get really sophisticated, you can add the amount tied up in property, plant and equipment, call that tangible capital employed, set it as the denominator under profit, and see what returns you are earning on the capital you have tied up in the business. Perhaps you’ll find you’d be better off buying a Treasury bond and sitting on the beach.

Cash is King. Profit numbers live in the accounting fantasy world we call “earnings” and have all sorts of things in them. Understand where your cash is coming from and what it is being consumed by and you’ll be a long way down the path of being able to keep some of it for yourself.

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