All organizations know the importance of managing cash and working capital; without them, organizations simply cannot exist. Yet, when targeting growth, too many organizations focus on trying to increase sales or reduce supplier costs, while ignoring the potential benefits of efficient working capital management.
A renewed focus on internal processes can unlock working capital “trapped” in the cash conversion cycle, which is then available to be recycled back into the business. Freeing this cash has a direct impact on the business’s bottom line. It allows the business to grow, without making another sale, simply because working capital that was previously being used to fund an inefficient process can now be invested to help the company achieve its strategic objectives.
How to calculate the cash conversion cycle
The cash conversion cycle is a measurement of the time a company must finance the costs of making products or delivering services before receiving payment for them. It is calculated using the following equation:
Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
The three core concepts in this equation are:
Days Inventory Outstanding (DIO). Days inventory applies primarily to manufacturing companies, as it provides a measurement of the time it takes to turn raw materials and other inputs into the sale of finished goods. DIO is a combination of raw materials in the warehouse, work-in-progress and unsold finished goods. Services companies have a very short DIO due to their limited inventory.
Days Sales Outstanding (DSO). Days sales (or days receivable) is the average time it takes for the company to collect payment from customers following the sale of finished products. For companies that sell cash on (or before) delivery, DSO will be a few days; for those that sell on credit, DSO will be close to their normal credit terms.
Days Payable Outstanding (DPO). This is the average time between procuring raw materials and other inputs and paying the suppliers. During this process, the company’s suppliers are providing the goods on credit. If the company usually has to pay cash on (or before) delivery, then the DPO will be close to zero. If the company pays all its suppliers exactly 30 days after ordering, then its DPO will be 30 days.
The resulting cash conversion cycle is the average time between when a company has to pay for raw materials and when it receives payment for the finished goods. For a services company, it is effectively the average time between the day the service is provided and payment is received.
Put another way, DIO and DSO are the average time between a company procuring raw materials to manufacture its products and receiving payment from customers for the sale of those products. This is financed by a combination of supplier credit (DPO) and company-sourced financing, either from reserves or external borrowing.
Every company will have a different CCC, which is determined by both its own internal efficiencies and the conventions and practices in the markets in which it operates — standard payment terms vary both by industry sector and by country. In theory, companies will try to minimize their CCC, which can be done by reducing DIO (e.g., by operating a lean production cycle) and DSO (e.g., by accelerating collections) and/or by increasing DPO (e.g., by delaying payment to their suppliers).
From a cash flow perspective, it is evident that the faster a product can be made, sold and converted into cash, the better it is for the company. From a shareholder’s perspective, the lower the CCC is, the smaller the working capital funding requirement and, consequently, the more value created for shareholders.
Manage working capital to influence the cash conversion cycle
All companies view cash — and working capital more generally — as the critical assets needed to achieve their business objectives. Managing working capital efficiently provides companies with a degree of resilience against external events, a position emphasized by the impact of the 2020 global lockdown on business activity and the associated cash flows.
By reviewing the way working capital is managed, companies can influence their CCCs, strengthening their business and building shareholder value. There are three key levers:
Increasing DPO. Trying to extend DPO (i.e., to increase the use of supplier credit) has been a common way to improve the CCC. Procurement decisions are squarely within a company’s control, and finance is able to determine when to make payments to suppliers. Moreover, it can often be easier, especially for larger organizations, to impose longer payment terms on their smaller suppliers than to identify efficiencies elsewhere. More generally, while it is good for the company’s own working capital position to delay payment as long as possible, it should consider the impact of delaying payment on its own supply chain. It may not make good long-term business sense to put suppliers in a position where their own cash flow is under pressure.
Reducing DIO. Establishing lean procurement and production processes has long been seen as an effective way to reduce the CCC. Inventory management software allied to “just-in-time” methodologies allowed companies to reduce the DIO and minimize warehousing costs. However, as the effects of the 2020 lockdowns affected physical supply chains globally, many organizations have been reviewing their “just-in-time” processes, and reassessing the robustness of their supplier base, making reducing DIO more difficult.
Reducing DSO. The final lever is to accelerate receivables, albeit in an environment in which customers are seeking to preserve their own cash. Companies are looking to do two things to improve their DSO: make their internal receivables processes more efficient by taking advantage of tools to capture and process data more quickly, and make it easier and more convenient for customers to pay.
Ready to unlock the working capital “trapped” in the cash conversion cycle? Check out the AFP Payments Guide to Unlocking the Cash Conversion Cycle to get started with a sample spreadsheet.