The Final Key To Improving Cash Flow — How to Compute The Cash Conversion Cycle


Why is Knowing How to Compute The Cash Conversion Cycle (CCC) Important to my Business?

Understanding how CCC affects the ways in which a business utilizes its most precious resource–CASH–is a categorical imperative for all business owners.  By monitoring CCC results combined with understanding and influencing the metrics that underpin the CCC metric will pay huge dividends and increase your business’ viability well into the future.

The CCC metric pulls together three other working capital metrics we posted about earlier–Days Sales Receivables (DSR), Days Inventory On Hand (DIOH) and Days Payables Outstanding (DPO).  A CCC metric is computed as follows:

DSR + DIOH – DPO = CCC (lower the  better!)

You are probably thinking, “that’s it?”  Well yes, that’s it.  I know it appears a bit abstract at first.  But once you have finished this post, you will have an excellent understanding of how to better control your cash flowing using this working capital metric. 

The key to increasing cash flow is understanding how to compute the cash conversion cycle. This includes knowing what actions are needed to decrease the cycle time. Click to Tweet

If you do not already have a good grasp on DSR, DIOH or DPO, use the links above and review those posts first, then return to this example where I pull it all together for you. 

Are you back?  Great, let’s get started…

An Example Illustrating How CCC Correlates to Cash Flow Management

In this simple example, we are going to follow a bicycle gear through a business cycle (i.e. purchase part, create inventory, pay vendor, invoice customer and collect cash) to illustrate the CCC.  Assume that the hypothetical business is a bicycle wholesaler, selling assembled bicycles to retailers in the area.  The business purchases bicycle components and assembles them into finished bicycles, based on their customer’s orders and specifications.  All sales are on credit, invoiced with 45-day terms from shipment date. 

Step #1: Purchase Bicycle Components (Gears) From Vendor (This is the DPO component of the CCC)

Without bicycle parts, our business does not have much to sell.  The person responsible for purchasing issues a Purchase Order for bicycle gears.  Assume that we have negotiated 45-day payment terms with our bicycle component vendors.

The 45-day payment clock does not start until the inventory arrives at our facility.  With that arrival, we post a debit to inventory and credit to accounts payable.  Now we are just awaiting the actual invoice to arrive.  But the date the invoice arrivals is not the starting date.  The start date is when the gear is received at our facility and are entered in the inventory management system.

From our illustration below, you can see that the gear arrives on Day 0, along with the vendor invoice (that vendor is speedy).  Per our negotiated terms, we issue a check to our vendor on day 30.

Illustration of how DPO works from a business owner's perspective

Step #2: Assemble a Bike to Our Customer’s Specification.  (This is the DIOH component of the CCC)

Assume that we are starting another clock, which is actually the DIOH clock, on the day we receive the gear (Day 0 below).  We maintain the gear in our inventory until we receive an order for a bicycle that specifies our gear in a Bill of Material (BOM), at which time the gear is “consumed” in the finished bicycle assembly process to create a finished bicycle.  View the illustration below.

Illustration of how DIOH works from a business owner's perspective

In our example above, we received the Gear on Day 0.  More than likely it idled in our inventory for a couple of weeks before receiving the order from our customer.  At that point, we quickly created a work order, assembled the bike and closed the work order as complete.  Then 45 days following the date we received the Gear, we shipped the bike (including the gear), as part of a finished bicycle to our end customer.  Given that we held the Gear for 45 days, our DIOH is 45.  

Step #3: Ship Bicycle, Invoice Customer and Collect Cash (This is the DSR component of the CCC)

As you can see in the illustration below, our Gear is being loaded, as part of the finished bicycle, into the truck on Day 0.  Once again we are starting another clock, which is our DSR clock.  This clock begins, essentially, on the day the inventory item leaves our facility.  There are nuances like FOB Source or Destination, but those distinctions are for another day. 

This is a good customer given that we have extended 60-day payment terms.  We are able to get the invoice out on Day 0 because our ERP system emails invoices automatically.  Then as you can see below, on Day 60 we receive the check that stops the DSR clock on this shipment at 60 Days.

Collections is one of the most important business process functions you will oversee.  It is critical that invoices are issued in a timely and accurate manner.  Extending 60-day terms is rather generous, but in our example, this is a stellar customer.  They pay on time and do not load us up with claims for chargebacks; consequently, we decided to extend generous credit terms.

Step #4: Pulling It All Together — Cash Cycle Days

Finally, we have all the pieces and can compute our CCC metric.  You can see in the top section of the graphic below, when adding the current asset parts–DIOH and DSR–you get 105 Days.  Then when you subtract DPO, the net is a Cash Conversion Cycle equal to 75 Days.  Hopefully the illustration makes it clearer why you subtract the DPO from DSR + DIOH.  The reason is that are taking advantage of OPM (Other People’s Money).  The business did not have to disburse a dollar until 30 days into the CCC time frame.  You, as the business owner, spent your first dollar on Day 30.  Subtracting the 30 Day DPO from the 105 Days DSR + DIOH, gets you to a CCC of 75 Days.  

Illustration of how Cash Cycle works from a business owner's perspective

You can see from the above that the CCC is effectively the number of days from when you disbursed the first dollar until you are able to collect that same dollar (metaphorically of course, but money is fungible).  Obviously the fewer days the better, which you can think of as the velocity of money circulating in your business.  A lower CCC equates to a higher velocity.  A higher velocity of money translates into lower levels of debt required to sustain your inventory and credit policy.  Less debt also means more cash in the bank account at month end and lower interest expense.

I have heard the term “Your Vendors Are Your Lenders,” how does that work?

Large retail companies, such as Walmart, that have significant leverage over their vendors, can approach and in some cases achieve a negative CCC.  Given that retailers do not generally have to extend credit, because most of their sales are cash, they will effectively have a 0 DSR.  If these businesses can negotiate 45-day terms with their vendors and maintain a very lean inventory, then they can potentially approach a negative CCC.  Conceptually, what is happening is that these businesses are able to sell inventory prior to having to pay the vendors that provided the inventory.  Even this is difficult for Walmart since a large amount of their inventory is sourced from China.  You can bet Walmart has negotiated agreements where they do not pay their vendors until the product has, at the earliest, been received in the U.S.; otherwise, Walmart could not achieve the DIOH levels they regularly achieve (41 DIOH as of YE 2019).

Tools You Can Use to Monitor Your Cash Conversion Cycle Performance

Below is a graph format we use with clients to help monitor and influence their cash flow by reviewing DSR, DPO, DIOH and CCC. In the graph below, DSR, DIOH and DPO are represented a columns and the CCC is represented by the line.  You can see that this client needs more focus on managing their current assets given their CCC was at 240 days as of ME February. 

In addition to the graph, we added some key indicator lights toward the top right to reflect the month-over-month change.  So if a key metric is 5% worse than the prior month, the indicator is Red, better the 5% over the prior month is Blue and between the two is green.  This provides a quick review of how the metrics have changed over the prior month.

Cash Conversion Cycle Monthly Graph displaying DSR, DIOH and DPO performance as columns and the Cash Conversion Cycle as a line with all metrics deteriorating.

We hope you have a better sense for managing your company’s Cash Conversion Cycle and can implement some of the ideas we have presented in this blog post.  We are sure they will pay significant dividends in the near future.  If you would like a copy of the above graph, use the Contact Us link below to reach out and request a copy.  Additionally, if you are a business owner that is looking for ways to leverage your data analytics, please contact us today

 

About the Author
About the Author
Chase Morrison  provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.

 

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The Value of Financial Benchmarking


Why Benchmark Your Company

Is benchmarking an integral part of your strategic planning process?  If not, you may want to consider adding a review of your industry’s key financial metrics to your next planning session, because what you don’t know can really hurt you.  For example, what if you discover that your industry average accounts receivables turnover is 25% faster than your collection metric?  There may be something amiss in your assumptions, relative to the terms you provide, in contrast to your industry.  What could you do with the additional cash flow generated via a 10% improvement in collections?  How about 20%?  What is your competition doing with their excess cash?  Perhaps they are developing new products/services that would detrimentally affect your market share.

The value of financial benchmarking can be immeasurable given that it will push your decision making toward continuous improvement of financial metrics. Click to Tweet

Just as you look to your industry for comparisons, you should be looking at different departmenst and plants within your own organization for similar opportunities.  Is one sales rep more successful selling product A than another?  Is one deparment more successful renewing contracts than the other departments?  Is one plant able to meet and exceed quality standards with fewer resources?  These are the things that benchmarking can help you ascertain.  Once identified, you will then want to replicate best practices across the organization.

How To Benchmark Your Company

To get started, begin looking within your industry.  Try to summarize your company data quarterly for two to three of years to help you identify positive or negative trends.  You will want to select a broad measure to start, such as return on assets employed (ROAE).  ROAE (net income divided by total assets employed) is a great measure of efficiency, because the metric reflects how efficiently a business is deploying the assets that have been provided by shareholders and lenders. 

Places to look for industry-based benchmark metrics include industry trade associations, look up 10K filings for similar companies in your industry on the SEC’s EDGAR website, or do what I do, refer to the Almanac of Business and Industrial Financial Ratios (ABIFR), from CCH:

Almanac of Business and Industrial Financial Ratios

The ABIFR is organized by major NAICS codes, which means that not every NAICS code is represented; consequently, you will need to find a close match if an exact NAICS match is not available.  Within each NAICS code, companies are categorized by asset size.   Some of the metrics include: There are 50 metrics presented for each industry, including: 1) Operating Income, 2) Cost of Operations; 3) Operating Margin; 4) Average Net Receivables; 5) Average Net Inventory; 6) Average Total Assets and many others. 

Metrics that balance profitability and efficiency are best benchmarking choices, rather than more narrow alternatives, such as gross profit %.  For example, companies can “game” gross profit % in the near term by extending overly favorable terms, such as longer than standard collection terms, in comparison to their industry competitors.

Once you start analyze your company’s performance to industry benchmarks, you are going to want to begin digging deeper to see what components of ROAE are the performance drivers of your competitors, e.g. how are competitors performing on inventory turns, days sales outstanding, profit margins, etc.  All this analysis can then be fed back into your strategic planning process.

Benchmarking Within Your Company

As we mentioned earlier, an excellent source of performance improvement opportunities can be derived by benchmarking your own organization.  By comparing one organization to another, we are always surprised by what we find.  There are nearly always centers of excellence in every organization.  You just need to find them and figure out how to duplicate their success.  Here a few benchmarking tips on leveraging your centers of excellence:

  1. Use a corporate team to do collect the data;
  2. Try to find one best in class item within each business unit;
  3. Don’t spend time trying to figure out why one process works better than another, so much as just getting the process duplicated;
  4. Provide ample opportunities for recognition; and
  5. Monitor & report results to the teams.

One great byproduct of benchmarking is the competition that ensues.  Just the competitive nature of most directors and VPs is enough to gain 5% to 10% of improvement, as performance metrics begin to be collected, even before the benchmark findings are tabulated.  But once the findings are established and the best practices begin to take effect, you will want to figure out how to reset the bar, because your internal benchmarking needs to become the foundation for your continuous process improvement efforts.  And finally, your compensation program will need to be adjusted to align with some of the benchmarking efforts to keep everyone’s eye on the ball.

We know this is a brief explanation of this important process, but hopefully there are a couple of nuggets that helps you grasp the value of financial benchmarking that will  push your efforts forward.  If you need help setting up ways to benchmark your organization, please give us call.  We have the tools to help.

 

About the Author
About the Author
Chase Morrison provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.

 

 

Astros Baseball Lesson For Business Owners – Leverage Data Analytics


A great article in the Wall Street Journal this week, “The Houston Astros and the Transformative Power of Analytics ” by Irving Wladawsky-Berger, based on an interview with Astros GM Jeff Luhnow about the important role analytics played in their recent success.  Mr. Wladawsky-Berger did a great job describing how the Astros leverage data analytics in the management of their ball club along with many of the challenges that were overcome along the way to their World Series victory over the Dodgers last year.

Wall Street Journal article with important takeaways for business owners on how to implement and leverage data analytics. Click to Tweet

At Profitwyse, we focus on helping our midsize business clients build data warehouses based on transactional data that is culled from their accounting and ERP systems and then establish various data analytic tool sets; consequently, we see a number of lessons in this article that business owners should take to heart and gain a competitive advantage in their own markets.  Here are several relevant takeaways for business owners.

Implementing Data Analytics Requires a Culture Shift

Early in the article, Mr. Wladawsky-Berger quotes Mr. Luhnow as follows:

“There are hundreds of people that work in a baseball organization, including coaches, scouts, and hundreds of players that are signed at any one point in time,” he said. “They did not accept it right away. For certain elements of the analytics, we had to wait and be patient. Because if you can’t get the coaches and the players to buy into it, it’s not going to happen.”

We see this culture shift barrier happen with our clients, but there is a simple solution for the business owner and it requires a modest amount of money.  When we implement a system of metrics, whether the metrics are based on data analytics or some other source, we have found that the critical component is linking compensation to the metrics.  The amount of compensation does not have to be large for most rank and file employees to get them to take notice and engage in the program.

Data Analytics Need to be Easily Understood

Most teams in Major League Baseball now employ small teams of statisticians and other data analytics specialists, many with advanced degrees.  This creates a communication barrier between the technical specialists and the coaches as well as players.  The data analysts think in terms of standard deviations and multiple regression forecasting models while the coaches and players think in baseball terms.  This barrier created the need for translators to overcome this communication barrier, as Mr. Wladawsky-Berger writes here:

The team also hired extra coaches at each level of the organization who believed in and could explain the reasons for the changes to the players and coaches, thus playing the role of translators between the analytics and baseball worlds.

With our clients and their systems of metrics, we adhere to the Keep It Simple Stupid mantra.  Most of our clients cannot afford full-time translators; consequently, we keep the metrics fairly rudimentary and less abstract.  For example, we would focus on labor hours per part, quality incidences in a given month, dollars of scrap per month and cycle time per component.  This is in contrast to metrics like Days of Inventory on Hand, Customer Service Level, Mean Time Between Failure and the like. 

It is Going to be an Evolution Not a Revolution

Mr. Luhnow has been with the Astros since 2011.  The Astros just won their first World Series in 2017, 6 years Mr. Luhnow took the helm and 55 years after the team was established in 1962 (originally as The Colt .45s, anyone thirsty?).  As business owners should conclude, implementing a system of metrics based on data analytics will require a continuous improvement mentality and a long-term objectives.  In the article, Mr. Wladawsky-Berger quotes Mr. Luhlow talking about the difference between 2002 baseball data analytics as compared to today:

“Today, it’s completely different. We now have so much technology around the ballpark and information about the trajectory of the ball, the physics of the bat swing, the physics and the biomechanics of the pitcher’s delivery – so many components now that advanced sciences have worked into our game. ”

The key take away for business owners is that they are not going to get it perfect right out of the blocks, but need to keep plugging away, developing new information resources and gaining valuable new insights along the way.  Again, one of the keys is maintaining a continuous process improvement mentality around data analytics and the system of metrics that evolve from those analytics.

If you are a business owner that is looking for ways to leverage your data analytics, please contact us today

 

About the Author
About the Author
Chase Morrison  provides CFO services, utilizing Profitwyse’s 3D Growth Platform™, enabling his business owner clients to more readily achieve their goals for wealth creation and family legacy.  Contact him today to learn how your business can hit the accelerator using Profitwyse’s proven platform.