27
Homing In on Cash Conversion
In this chapter we’ll take up the cash conversion cycle, which measures how effectively a company collects its cash. But there’s one little wrinkle we have to consider first—how fast a company decides to pay the money it owes its vendors.
Accounts payable is a tough number to get right. It’s an area where finance meets philosophy. Financial considerations alone would encourage business owners to maximize days payable outstanding (DPO), thus conserving their company’s cash. A change in this ratio is as powerful as a change in the other ratios we’ve been discussing. For instance, in the imaginary company we’ve looked at in many chapters now, if managers increased DPO by just one day, they would add about $19,000 to the company’s cash balance.
But there are other considerations, as we mentioned in chapter 22. What kind of a relationship do you want with your vendors? What kind of reputation do you want? In practical terms, how much leverage do you have with your vendors—will they even continue doing business with your company if it is a late payer? Another practical consideration is the Dun & Bradstreet rating. D&B bases its scores, in part, on a company’s payment history. An organization that consistently pays late may find that it has trouble getting a loan later on.
A personal story may illustrate the point. Joe’s company, Setpoint, never lets an invoice go beyond thirty days. The company’s philosophy is that slow payments simply aren’t good business. Where did that philosophy come from? When Joe’s partners, both engineers, started Setpoint, they had recently left another company. There, they had been project managers, designing custom products for the company’s customers. But when they sent their designs out to be fabricated, nobody would build parts for them. When they asked why not, they found that their employer regularly took more than one hundred days to pay its bills. In effect, the engineers had to become negotiators just to get their projects built! When they started their own business, they vowed they would never put their new company’s engineers in that position. While the philosophy puts constraints on cash flow, Setpoint’s leaders believe that it positively affects the company’s reputation and relationship with its vendors—and in the long term helps Setpoint build a stronger community of businesses around itself.
In general, if you notice that your company’s DPO is climbing—and particularly if it is higher than your DSO—you might want to start asking a few questions. After all, the success of the company probably depends on good relationships with vendors, and you don’t want to mess up those relationships unnecessarily.
THE CASH CONVERSION CYCLE
Another way to understand working capital is to study the cash conversion cycle. It’s essentially a timeline relating the stages of production (the operating cycle) to the company’s investment in working capital. The timeline has multiple levels, and you can see how the levels are linked in figure 27-1. Understanding these levels and their measures provides a powerful way of understanding your business and should help you make financially intelligent decisions.
Starting at the left, the company purchases raw materials. That begins the accounts payable period and the inventory period. In the next phase, the company has to pay for those raw materials. That begins the cash conversion cycle itself—that is, the cash has now been paid out, and the job is to see how fast it can come back. Yet the company is still in its inventory period; it hasn’t actually sold any finished goods yet.
Eventually, the company does sell its finished goods, ending the inventory period. But it is just entering the accounts receivable period; it still hasn’t received any cash. Finally, it does collect the cash on its sales, which ends both the accounts receivable period and the cash conversion cycle.
Why is this important? Because with it, we can determine how many days the cycle takes and then understand how many days a company’s cash is tied up. That’s an important number for company owners to know. Armed with the number, entrepreneurs may be able to find ways to “save” lots of cash for their company. To figure it out, use the following formula:
cash conversion cycle = DSO + DII – DPO
In other words, take days sales outstanding, add days in inventory, and subtract the number of days payable outstanding. That tells you, in days, how fast your company recovers its cash, from the moment it pays its payables to the moment it collects its receivables.
The cash conversion cycle also gives you a way of calculating how much cash it takes to finance the business: you just take sales per day and multiply it by the number of days in the cash conversion cycle. Here are the calculations for our sample company:
This business requires working capital of around $1.8 million just to finance its operations. That isn’t unusual for a growing company. Even small companies require a lot of working capital relative to their sales if their cash conversion cycle is as long as sixty days.
Companies of any size can get themselves into trouble on this score. Tyco International—mentioned earlier in this book—was famous for acquiring six hundred companies in two years. All those acquisitions entailed a lot of challenges, but one serious challenge involved huge increases in the cash conversion cycle. The reason? Tyco often was acquiring companies in the same industry, and competing products were added to its product list. With several very similar products in inventory, the company couldn’t move that inventory as fast as it once had. Inventory days began to spiral out of control, increasing in some parts of the business by more than ten days. In a multinational company with more than $30 billion in revenue, increases on that scale can deplete cash by several hundred million dollars. (This is an issue that Tyco has addressed in recent years by closing down the acquisition pipeline and focusing on the operations of the business.)
The cash conversion cycle can be shortened by all the techniques discussed in this part: decreasing DSO, decreasing inventory, and increasing DPO. Figure out what your company’s cycle is and which direction it’s heading in. You may want to discuss it with your managers. That might start a conversation that will result in a faster cash conversion cycle, lower working capital requirements, and more cash. That will benefit everybody in the business.