Have you noticed in various media outlets a dramatic increase in the use of clichés describing the importance of cash in your business?  I have seen and heard them all…classics such as “Cash is the Lifeblood” or “Cash is the Oxygen” of your business…they are all being used at an alarming rate.  However, the granddaddy of all “cash” clichés has to be “CASH IS KING”.  I must admit, I have used them all myself.  I apologize ahead of time, but I’m going to actually employ the old granddaddy cliché as a starting point for my discussion…so get ready…here it comes.

If “Cash Is King”, then most likely your “monarch” is being held captive on your balance sheet among your other working capital assets – and it is time we devise a plan to LIBERATE YOUR CASH!

This article is going to be a little technical, but very practical, for business owners.  With credit drying up from the usual sources, generating cash from internal sources has taken on a renewed level of importance.  Working capital management is arguably the most important management activity in emerging and mid-sized companies because of the significant financial impact that it has on the company's well-being.  When working capital is not adequately managed, the deterioration of cash flow critically affects a company's ability to fund operations, reinvest in the business and, ultimately, to survive.  However, with adequate working capital management, cash flow supports a company that thrives in the marketplace.

Working capital management is a very broad topic and it would take up much more room than allotted here in this column to cover it completely.  So for purposes of this article, my comments are going to be confined to talking about measuring and improving your company’s Cash Conversion Cycle, and how this could have a dramatic impact on internally derived cash flows.

Measuring the Cash Conversion Cycle

The Cash Conversion Cycle (CCC) is a financial indicator that is a combination of several financial activity ratios involving inventory, accounts receivable, and accounts payable and measures how fast a company can convert these core working capital assets and liabilities into cash on hand.  Generally, the lower this number is the better for the company.

The Calculation

CCC = DIO + DSO - DPO

DIO = Days Inventory Outstanding:  A financial measure of how long it takes a company to turn its inventory (including goods that are work in progress, if applicable) into sales.

DIO = Average Inventory/Cost of Goods Sold per day

DSO = Days Sales Outstanding:  A financial measure of the average number of days that a company takes to collect revenue after a sale has been made.

DSO = Average Accounts Receivable / Revenue per day

DPO = Days Payable Outstanding:  A financial measure of how long a company is taking to pay its trade creditors.

DPO = Average Accounts Payable / Cost of Goods Sold per day

Improving the Cash Conversion Cycle

Your company can lower its Days Inventory Outstanding (DIO) measure by a variety of inventory management techniques that improve the alignment of inventory with demand.  A thorough review of your credit and collection policies and procedures would reveal what may be driving up your Days Sales Outstanding (DSO) measure.  Be sure to review whether credit checks are being done, whether customers being billed promptly with accurate invoices and adequate documentation for payment, whether customers are being reminded about amounts due and their due dates, and whether accounts receivable aging reports are being reviewed regularly to aggressively collect on past due balances.  Consider taking full advantage of supplier’s payment terms to increase Days Payable Outstanding (DPO), which will allow you to hold cash as long as possible, but do so without jeopardizing your company’s credit rating.

Conclusion

Adequate working capital for business varies, often extremely, from a small business to a large business, from an under-capitalized company to a well-capitalized company, from a growing business to a business declining in size or sales, certainly from a start-up company to a mature company, and it varies from one day to the next.  However, closely monitoring and improving a company’s Cash Conversion Cycle over time to the lowest possible ratio, will be a surprising source of internally generated cash, which could lower the cost of carrying any other sources of financing.

Contact William Wright at (757) 685-2455 or by email at wwright@b2bcfo.com