Understanding the Cash Conversion Cycle and How to Speed It Up
Have you ever encountered a business that is profitable, yet does not have the money it needs to pay its bills? This is a plague for many small businesses and farms. You see, it takes cash to pay bills. You cannot take an account receivable and give it to your utility company to satisfy your electric bill. You also cannot give your bank excess inventory you have to make your mortgage payment.
The process of taking cash, turning it into a product, selling the product on account, and then collecting on that account is the cash conversion cycle. How many stops must cash take along the path from initial cash, then adding value of some form, and finally collecting cash at the end. This is important for a business to know since, after all, cash pays the bills.
So let’s start the trip along the cash conversion cycle. Now every stop on the way may not apply to some businesses. Also, if the company does not have enough money to satisfy all debts at each point of the cycle, then it has a borrowing need to help fund inventory, receivables, or production.
Stop 1: Purchasing materials to create a product. This step will not happen with a company that does not make a product or grow a crop. If the firm carries no inventory than there will be no funds that are spent here. Also if a company provides a service such as a computer repair company and carries no inventory, no money will be spent here.
The time spent here, from company to company, will also vary. A potato chip plant may have potatoes delivered and dumped into a bin at the start of a day, and bags of potato chips are shipped just hours later. A company that makes durable goods, such as aircraft, will take more time in this stage of the cycle. When cash is spent on material and labor to produce the product, it is not available for other operating expenses. Some tips to manage this stop are:
· Watch material and inventory levels and do not purchase more than what is needed. Doing so is a use of cash and can hamper profits. I once saw a hardware store that would borrow money to purchase the product for resale. When they sold that product, they would not pay off the bank loan, they used it to purchase more items to sell.
· Note the average time frame that it takes inventory to turn over with other companies in your same industry. The hardware store I mentioned only turned their inventory over once a year, when the industry average was much quicker. As such, they to continue to borrow money to operate, which left them with an unsustainable level of debt.
· Suppliers can provide a source of cash if they provide you with generous terms. I once studied a restaurant that had no debt on their building, fixtures, or operating line from their bank. They sold over $3 million annually and supplied all their cash needs by paying for food on 45-day terms with their supplier.
Stop 2: Taking the product you produced to market. This step happens once a company has completed creating the item and is taking it to market to sell. Different industries have different time frames for this step in the cycle. Also, sometimes, a firm may intentionally stay at stop two. An example here is if a farmer harvests crops and waits to sell the product as he is expecting to get a better price in the future. That may work, but there is also a carrying cost to holding onto an item instead of selling it.
It is important here to not over produce your sales demand, as this will cost you money. Also, learn to be disciplined in your selling approach. Always trying to grasp the brass ring of the highest possible price for your product often comes with a cost of capital. You may not be making as much profit in the long run as you think.
Stop 3: Collecting money on an account receivable. This step does not apply to some firms. If you are a retailer and sell no items on account, this step does not apply. But if you sell a product or complete a service and then create an invoice for the buyer, this step applies to you.
It is important to see how your company stacks up against the industry. If it takes you much longer to collect your receivables, you will use more cash than similar companies. It is possible to run a profitable business but to be in need of cash. Many times this is because of a lack of collecting your accounts on a timely manner.
Here some methods may be to offer a slight discount if an invoice is paid within 10 days. You also may consider the extra cost on your business to collecting accounts slow. This may need to be built into your price. If accounts cannot be collected quickly enough to satisfy cash needs, then the company may need to borrow on an account receivable loan or turn to factoring to receive cash quicker.
Managing the cash conversion cycle and minimizing the natural stops can make a huge difference in the cash needs a business has to have to operate. Simple steps like paying suppliers slightly slower, managing inventory levels, and speeding up the collection process could minimize or eliminate the need for an operating line for the company.