Cash is the lifeblood of any enterprise, and the size of the business usually determines the volume of the cash reserves. Typically, small businesses are most affected by liquidity constraints due to their smaller reserves; these businesses can "bleed out" pretty quickly in times of adversity, leaving them with no means of handling basic expenses.
With this in mind, the cash conversion cycle - also known as a net operating cycle (or simply a cash cycle) - can be a valuable tool for your business if it is vulnerable to frequent liquidity constraints. Here we will take a closer look at what the cash conversion cycle is, and how it can benefit your business.
What is the Cash Conversion Cycle?
The cash conversion cycle is a metric in business accounting and management that measures the time taken by an enterprise to convert its input costs and other inventory investments into cash received.
The premise behind this metric is quite simple and straightforward - in business, you have to spend working capital to create inventories of products and goods. Often there is a gap between the sale of goods and the actual receipt of cash in your business accounts.
This is particularly the case in B2B segments, where accounts payable and accounts receivable are an integral part of business life. Often you will find your funds getting tied up as you wait for your clients and customers to honour their end of the sales transaction.
Using the cash conversion cycle, you can figure out how long it takes the production and sales departments to convert input dollars in cash income received, meaning that it is a critical metric for figuring out the overall operating efficiency of your business.
The Three Factors That Determine the Cash Conversion Cycle of an Enterprise
The cash conversion cycle has a fixed mathematical formula with three main components, all of which are measured in days:
Days Inventory Outstanding (DIO) is the time taken by your firm to sell the inventory of goods or raw materials manufactured. It measures how quickly you can empty your inventory, or in other words, how long your stock remains unsold. In general, having a lower DIO is preferable for most businesses.
You can calculate the DIO of your business using the following formula:
DIO = (Inventory/Cost of Sales) x 365
Days of Sales Outstanding (DSO) is the time taken by your collections & cashiering teams to receive monies that are owed to your business by your clients. It is a clear indicator of the efficiency of your invoice management system. In virtually all cases, having a lower DSO is highly desirable.
The formula for calculating DSO is:
DSO = (Accounts Receivable/Total credit sales) x 365
The third and final component of the cash conversion cycle formula is called Days Payable Outstanding (DPO). This metric is a bit different from the other two. It shows how long it takes your business to pay up for goods and services received from your vendors and suppliers, or, rather, how long your vendors are willing to give you a credit period. From a cash cycle perspective, it is better to have a higher DPO.
The formula for calculating your DPO is quite similar to the other two components:
DPO = (Accounts Payable/Cost of Sales) x 365
Once you have these three basic components, calculating your cash conversion cycle is a simple and straightforward process. Just add the first two components and subtract the third one from it:
Cash conversion cycle = DIO + DSO - DPO
Implications of a Negative vs Positive Cash Cycle
Usually, there is a delay between the due date for payment towards your suppliers, and the receipt of cash from the sales of your products or inventory. This is understandable, given the gap in time between both transactions - you buy raw materials from your suppliers and then manufacture the goods which are later purchased by your customers.
Generally, this results in a positive cash cycle figure for most businesses. The implication here is: you spend your working capital, then earn the revenue which replenishes your working capital, thus continuing the cycle.
Having a shorter cash cycle is always desirable as it speeds up the overall operations of your business. The quicker you get the cash, the faster you can spend it on your next round of manufacturing. Also, a shorter cash cycle reduces the level of uncertainty in your business - you don't have to worry about defaulting your future accounts payable.
While the majority of enterprises strive for a shorter cash cycle, certain firms can have negative cash cycles. This is usually the case if you have excellent relations with your vendors and can get better credit terms with longer payout deadlines.
It can also happen if you are in a sector where you can sell quickly and get paid instantly in cash, such as online retail. This is why many manufacturers also try to operate in-house retail sales departments. Faster inventory clearances also contribute to this, which can be achieved through streamlining and other efficiency-boosting measures.
Amazon and Apple are examples of companies with a negative cash conversion cycle, but not for the same reasons. In Apple's case, it is a combination of all the three probabilities mentioned above - they run a very efficient manufacturing division, have their own retail stores, and also buy in bulk from their many vendors.
Though it has an in-house brand of products, Amazon is more a platform for retail sales, rather than outright manufacturing. Given their massive size, they also have clout over their suppliers, which allows them to negotiate favourable terms for accounts payable while still managing to get instant payment from buyers.
Should the Cash Conversion Cycle Matter to Your Business?
From the above examples alone, it should be quite clear that the cash conversion cycle does not carry equal weight for businesses in different sectors. Manufacturing companies should be the most worried about having a favourable cash cycle as they have inventory management to deal with.
The same is also applicable to retail businesses that keep significant inventories, especially in the B2B sector. Those in B2C have a little less to worry about, as this segment usually involves quick cash payments.
The service sector does not deal much with inventories of products and is not unduly concerned about cash cycles, while certain firms dealing with virtual goods (such as software and apps) do not have to worry about inventory costs, either. These kinds of firms also don't have much use for cash cycle analytics.
How You Can Benefit from the Cash Conversion Cycle
There are several compelling reasons why a cash conversion cycle is essential to a business. It allows you to plan the future operations of your business by providing you with valuable insights regarding your liquidity.
A high cash cycle can also be an indicator of structural or functional flaws within your organisation. You can pinpoint the factors contributing to the overall inefficiency in your production, marketing, and accounts departments using this metric.
You can also use cash cycle analysis to compare your business with rivals. This can be crucial in a highly competitive market, allowing you to gain an edge on others. On the other hand, if you ignore this metric, it could put you at a serious disadvantage against your rivals.
What else can the cash conversion cycle tell you about your business? Let us know in the comments below.