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Shorten your cash cycle and keep more in the bank

December 8, 2016

By Frank Luengo, Sonora Foods Ltd. 

In a few days I will post some examples on operating ratios that you can use to monitor the day to day financial performance of your firm. However, before I do that I want to discuss the concept of cash cycle, or cash conversion period.

If you have worked with an A/R clerk, you know that they work hard to convert due accounts to cash in the bank. Purchasers try to minimize inventory on hand, and nobody writes a cheque in a hurry.

Each of these may sound intuitive, but there is a reason these roles are built that way, and it’s better when you see the big picture.

It all goes back to working capital. When you build inventory, you are having to make a cash outlay to service your customers. When you accept a sale on credit terms, you are using your cash to finance your customer’s purchase. And when a vendor offers you credit terms, you are using their cash to finance your business.

When you look at how much money you have tied up in inventory and receivables, and the amount financed in accounts payable, all as a fraction of sales, you get three ratios: Inventory Turnover, Receivables Turnover, and Payables Turnover. If you invert any of these ratios and multiply by 365, you will get the number of days, in terms of sales, that you have tied up.

I’ll use an example to illustrate this. Let’s say that you order $100 of inventory, and when it arrives in your warehouse, you are invoiced the $100. Also assume that you are given 15 days to pay that invoice. Now, let’s say that it takes 30 days to turn that inventory into a sale, when you deliver a finished good to your customer and invoice them. Now, let’s say that your customer has 30 days to pay.

If this happens for all your transactions you will get the following:

Inventory Days: 30

Payables Days: 15

Recivables Days: 30

Intuitively, it took you 60 days to convert that inventory into cash in your pocket. Take away the 15 days when you didn’t have to pay for your inventory, and you went a total of 45 days without the $100 that you needed to make that sale. In a formula, your cash conversion period C is:

C = ID + RD – PD

C = 30 + 30 – 15 = 45

Now, suppose you have an opportunity to get 45 days to pay for the inventory you ordered, and you get paid for your sale in 15 days. Now your cycle is 30 + 15 – 45 = 0. That is, you don’t have to have any cash tied up in order to conduct your business!

This is particularly important if your business is growing since any positive cash conversion period requires that you invest money in working capital to fund your growth. Many businesses fail to see this and run out of cash even though they are growing and profitable. Keep an eye on your cash, and this won’t happen to you.

This article was written by Frank Luengo, originally published on Frank’s Vault.