The Importance of Cash Conversion Cycles on Your Business' Financial Health

Introduction

• Your business' cash conversion cycle is integral to its financial health - without a healthy cash conversion cycle growing top line revenue might actually have the opposite effect on your cash balance.

Understanding Cash Conversion Cycle

• A cash conversion cycle typically has 3 main components: Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO), and Days Payable Outstanding (DPO).

  
  

• A lower DIO means less capital is tied up in inventory, freeing up cash for other operational needs. A lower DIO metric also displays faster inventory turnover, suggesting efficient inventory management and strong sales.

  • The formula for calculating DIO is (Average Inventory / COGS) * Number of Days in Period.

  • Average Inventory is usually calculated by taking the last two months' ending balances divided by 2.

  
  

• A higher DPO benefits you as that means you pay your vendors later which results in you holding onto your cash longer, again freeing up your working capital cash for other operational needs.

  • The formula for calculating DPO is (Average Accounts Payable / COGS) * Number of Days in Period.

  • Average Accounts Payable is usually calculated by taking the last two months' ending balances divided by 2.

  
  

• DSO is a financial metric that indicates how efficiently a company is collecting its receivables. The lower your DSO, the faster you are collecting from your customers which results in more cash on hand.

  • The formula for calculating DSO is (Average Accounts Receivable / Total Credit Sales) * Number of Days in the Period.

  • Average Accounts Receivable is usually calculated by taking the last two months' ending balances divided by 2. Total Credit Sales is usually the same two periods' top line revenues.

    
    

Impact on Financial Health

• Businesses that have low DIO, high DPO, and low DSO are in a healthy position and equates to your business collecting from customers before paying your vendors.

• The worst position to be in is if your DPO is lower than your DSO - this will result in negative cash impacts as your business expands. There is nothing more disheartening than seeing top line revenues grow but your cash dwindle over time.

• Implementing and maintaining efficient cash conversion cycle can lead to improved cash flow management. These metrics might seem like arbitrary financial metrics, but a small change in DPO or DSO can lead to large impacts to your cash balances.

  
  
  
  

  

Benefits of Optimizing the Cash Conversion Cycle

• Increased Cash Availability - optimizing your inventory, collections, and payables processes can free up cash for other investments or expenses. The more cash you have on hand, the better position your business is in.

• Enhanced Business Operations - a shorter cash conversion cycle can lead to better inventory management and procurement strategies.

• Improved Financing Opportunities - a strong cash conversion cycle can make businesses more attractive to lenders and investors.

Strategies for Improving Cash Conversion Cycle

If you determine that your cash conversion cycle is less than desirable, the below guidelines will help you improve it. In cases where you have existing contracts with vendors or clients, it is extremely beneficial to draft a new contract with better terms for new vendors or clients while also trying to negotiate existing contracts. In other words, do not delay implementing these improvement initiatives as the sooner you put these in place, the better position your business will be in. See our blog on long-range planning as that will help you understand how your existing DIO, DSO, DPO is affecting your business and will also show you how changing these will improve your business over time.

Ways to improve your cash conversion cycle:

• Inventory Management - reduce your business' inventory holding times through better forecasting and inventory practices. This can include both financial forecasting as well as process & system implementations.

• Accounts Receivable Management - timely invoicing and following up on payments to reduce receivable days are the two biggest factors in improving your DSO. If you do not have a collections policy, make sure you create and implement one that includes escalation steps after a certain amount of days. For significantly aged receivables (>180 days), onboarding a third party collections agency is one approach.

• Accounts Payable Management - the single key factor here is negotiating better payment terms with suppliers as that will optimize cash outflows. Start by contacting your vendors and see what options they can provide - you'd be surprised at their willingness to reduce payment terms. Another option is to finance your payable using an asset backed revolving line of credit, but ensure that the cost of capital on the line of credit is taken into account.

Conclusion

• The importance of cash conversion cycles for maintaining your business' financial health cannot be overstated. Every business has fundamental financial metrics that should be monitored and these are some of the building blocks of a health business. Cash is King.

• Ensure that there is continuous improvement and monitoring to ensure business sustainability and growth. A cash conversion cycle that is flipped will absolutely be detrimental to your business - and in a lot of cases you cannot entirely visualize just how big an impact DIO, DSO, and DPO will have until you complete a long-range modeling exercise.

  
  

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