Improving your cash conversion cycle
Introduction
Businesses are facing cash flow challenges due to inflation, rising interest rates and supply shortages. Because positive cash flows are the life blood to the business it becomes increasingly important to monitor these impacts on effective working capital management that generate these cash flows.
Having accurate and up-to-date information becomes critical to be able to evaluate the risks and establish corrective actions as needed. Organizations which have invested into integrated digital systems with readily accessible data are best placed to meet these challenges.
Understanding the Cash Conversion Cycle
The cash conversion cycle is the time it takes for a company to convert their working capital into the cash they need to make purchases, pay vendors and manage day-to-day operations. The time varies depending on the type of business; but in theory, companies with higher levels of inventory, like retail stores, will have longer cycles than companies with lower levels of inventory, like manufacturing plants.
Companies with an effective financial management system that monitors the cash conversion cycle can identify when there may be an issue and take corrective actions before they happen. This is important because right now many businesses are facing difficulties when it comes to cash flow.
For example, economic uncertainty can slow down sales or increase costs in materials or labor. When this happens, your company's cash flow may start to suffer. To combat these issues, you'll need to monitor your cash flows closely.
The future of the Cash Conversion Cycle
The Cash Conversion Cycle is the time between when a company pays its supplier, and when it receives payment from customers. When companies are looking to invest in their operating capital, the cash conversion cycle should be examined closely for indications of how well the business does at managing these funds.
One key metric to monitor is the Days Sales Outstanding (DSO). This measures the difference between days of raw materials on hand and days sales outstanding. The higher DSO, the more likely it is that your company will have difficulty meeting debt obligations due to low liquidity.
For example, if you have 40 days sales outstanding (DSO) with $2,000,000 worth of credit sales on average annually then you have $219,178 worth of receivables. However, if you reduce DSO down to 25 days sales outstanding on the same volume of credit sales then on average then you only have $136,986 worth of cash tied up in receivables. So by improving cash collections by 15 days the busines is able to make available $82,192 in cash to support operations.
Why it matters
Cash flow is the lifeblood that enables a business to function and grow. Without it, a company can't hire new employees or invest in new equipment. Without cash flow, a company won't make money and could even go out of business.
When cash flow is tight, smart business owners know how to stretch their dollars and keep their costs down by carefully managing their working capital. Cash flow management becomes all the more important when you have less borrowing availability or higher interest rates, as is the case now.
An integrated digital system with real-time data has many advantages for businesses today. It can help you monitor your cash flow situation, identify trends early on before they become problems, and give you better visibility so you can take corrective actions proactively before it's too late—saving your business from having to close its doors for good!
What companies should do to improve their cash flows
As the economic environment continues to change, new challenges arise. In order to stay ahead of these challenges and keep your company sustainable, it's important to analyze your current working capital.
Take a look at the following four steps:
- Establish systems and processes that enable you to keep watchful vigilance on your cash movements
- Determine the implications of inflation, tax and interest rates on your business and calculate its impact on cash flow
- Identify any areas where you can improve your working capital management practices, such as tightening your order to cash process or adjusting your purchasing terms with suppliers.
- Evaluate the effectiveness of your operations such as inventory management system and supply chain
Conclusion
The cash conversion cycle is a powerful tool that can help you manage your business finances and plan for future growth.
The rise of emerging digital trends like Blockchain e.g. Decentralized Finance (DeFi), digital assets (Cryptos and NFT's), and their implications for the future of the cash conversion cycle is uncertain, but I'll be sure to update you as I learn more.
In the meantime, keep reading my blog for more insights on this and other important financial topics!