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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.
Small business owners often miss how critical receivables management is to maintaining cash flow and controlling costs.
There are several strategic ways to go about this:
Reducing days sales outstanding (DSO). In my last blog, I talked about how to calculate the valuable DSO number. The most important thing you can do is start measuring your DSO regularly and consistently. Decreasing your DSO can free up more cash than you realize. Increases in your DSO can mean your customers are less satisfied than they were before. UPS, the shipping company, calculates DSO by customer. If they see a downward trend they immediately make a customer service call.
Your AR department is your most important customer service team. They are always dealing with your customers’ money and people are sensitive about money, even in a business situation. Developing the skills within your organization to take the emotion out of the AR process improves customer service. Every aspect of the sales cycle from order to collection is influenced by customer service. Recurring sales are often influenced by customer relationships; your AR department can cost you if it is not professionally monitoring and managing collections and customer relations. More often than not, the small business owners we talk to feel they should make the collections calls themselves. We feel that this is not a best practice – more about that in an upcoming blog.
Carefully reevaluate the assumptions behind your AR to collections policies. You may never make collections calls before 60 days because you assume your customers will be offended if you follow up before then. Would your aging improve if you made calls at 15 days to verify receipt of the invoice? Most non-payment is due to a dispute. The sooner you know about disputes, the more quickly they can be resolved, reducing the negative impact on your cash flow. What other assumptions are keeping you from successfully converting receivables to cash effectively?
Get creative. You know your business better than anyone. What can you do to decrease accounts receivable overhead and processing costs? Can you standardize price lists and proposals? Are you requiring written quotes? Can you standardize collection strategies by type or value of customer? Are you able to process alternative forms of payment? Is there any way to reduce sales cycle time?
Improving your AR management can lead to significant financial gains, something everyone wants for Christmas.
Let’s face it, cash is king. As a business owner, you know it is in your best interest to collect outstanding receivables as quickly as possible. Quickly turning sales into cash allows you to put the cash to use again to reinvest and make more sales. So which accounting calculation is your friend in helping you see if you are being effective at bringing money in? DSO or Days Sales Outstanding is the most widely used measure of back office efficiency by credit executives.
Without boring you like Charlie Brown’s teacher, I will explain why knowing it can ultimately help you improve your cash flow in the future and, then, let’s get to the meat of how this little equation works.
Why do you care about DSO?
When used consistently, this calculation can help you answer a variety of questions such as:
- What is the effectiveness of my credit and collection policies?
- Are my credit terms in line with competitors? The Credit Research Foundation (CRF) does a quarterly study, the National Summary of Domestic Trade Receivables (a.k.a., the DSO Survey), that is an examination of the condition of AR for U.S. companies. The results of the complete study are available to CRF members and those participating in the survey.
- Are my collections procedures successful in meeting my goals?
- Is my customer base risky?
- What is the real reason for the changes within my receivable balance? Was it a fluctuation in sales during that period, or are promotional discounts, seasonality or selling terms making the impact?
Unleash the DSO.
Days Sales Outstanding expresses the average time, in days, it takes your company to convert its accounts receivables into cash. There are several ways to calculate DSO. Each method for calculating DSO (outlined below) has its own strengths, and each is based on what might be called the Standard DSO formula. The key to making effective use of any of these tools is consistency. Select the method s that work best for you and stick with them.
- The Standard DSO calculation provides an average (aggregate) time in days it takes to convert accounts receivables into cash. It should be tracked over time and compared to previous company results or industry/competitor benchmarks
DSO = (Ending Total Receivables / Total Credit Sales) x Number of Days in Period
- Best Possible DSO utilizes only your current (non-delinquent) receivables to calculate the best length of time you can achieve in turning over receivables. It should be compared to the standard calculation above, and be close to your terms of sale. The closer your standard DSO is to your best possible DSO, the closer your receivables are to your optimal level.
Best DSO = (Current Receivables / Total Credit Sales) x Number of Days
- True DSO calculates the actual number of days credit sales are unpaid by tracking individual invoices to the month of sale.
True DSO = (invoice amount / net credit sales for the month in which the sale occurred) x number of days from invoice date to reporting date
Of course, if your DSO shows it is time to reign in those receivables, there are several strategic ways to go about this. We’ll delve into that next week . . . to be continued . . .
