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.

 

Day Sales Payable is critical part of cash flow management. Here are the details.

 

How to Compute Days Payable Outstanding or More Commonly “DPO” and Improve Cash Flow


Why is Knowing How to Compute DPO Important to my Business?

We have already covered importance of Days Sales Receivables (DSR), Days Inventory On Hand (DIOH), and now the final major operating cash flow metric–Days Payable Outstanding (DPO).  Where DSR and DIOH relate to current assets, DPO pertains to what is typically the largest current liability–Accounts Payable.  Like the other two metrics, business need to understand how to compute DPO and how it impacts cash flow. 

Unlike DSR and DIOH, the higher the number of days of payables outstanding, the better for a business owner.  Though DPO is as important as the other metrics, it seems to be lesser of a focus vs. the other two metrics.  This probably has to do the difficulty in acquiring the data needed to compute DPO.  But that does not make it any less relevant in your cash flow optimization strategy.

Learn more about your Accounts Payable turnover, how to measure and manage it, as well as why it is so important to your cash flow. Click to Tweet

We have already covered importance of Days Sales Receivables (DSR), Days Inventory On Hand (DIOH), and now the final major operating cash flow metric--Days Payables Click to Tweet

How to Compute DPO

Again, just as with DSR and DIOH, the DPO metric is retrospective in that we are looking in the rear-view mirror for context around future actions that will improve cash flow.   The formula for DPO is as follows:

Accounts Payable / Average Daily Disbursements = DPO

For the numerator, you need the month-end balance of your Accounts Payable account.  If your credit cards have balances, add those in as well to current the current accounts payable balance for your business.  Our total Accounts Payable balance should represent the current dollar value of outstanding invoices that a business has taken on credit (or likewise a vendor or bank has extended).  For this example, assume that the month-end April Accounts Payable and outstanding credit card balances totaled $475K. 

Computing the denominator, which is Average Daily Disbursements can be more difficult.  Ideally, what you want to accumulate is all the checks, wire transfers and cash payments the business has made over a given period.  Preferably that period should be 12 months, but can be shorter if you tend to pay your bills very quickly.  Cash payments, or disbursements, include payments for payroll, inventory, credit cards, professional services, etc. 

For our example business, we will assume the following:

  • Past 12 month checks issued = $2,000K
  • Past 12 month wires issued = $1,850K
  • Past 12 month cash payments issued = $50K
  • Total Disbursements = $3,900K
  • Daily Average Disbursements = $3,900K / 365 Days = $10.68K
  • DPO = $475K Accts Payable / $10.68K  = 44 Days Payable Outstanding (DPO)

Note: If you have Debt payments, include those payments in both the numerator and denominator or exclude it from both.

Why is Knowing and Influencing My DPO Metric Important?

As mentioned earlier, the larger the DPO metric the better for your business.  Your ability to increase this metric is directly related to your ability to negotiate favorable terms with your suppliers and vendors.  The more trust your suppliers and vendors have in your business, the more likely they are going to be willing to extend more favorable terms.  The more time your business has to make payments slows the velocity of cash required to sustain your business.  It does not reduce the amount of cash, but it does reduce the velocity. 

In our next post, we discuss the importance of DPO relative to the other cash flow metrics as part of our presentation on the Cash Cycle.  If you are a business owner that is in need of inventory management expertise to help implement your own continuous improvement initiative, 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.

 

Display of Receivables definition in purple highlighter

 

How to Compute Days Sales Receivables or More Commonly “DSR” and Improve Cash Flow


Why is Knowing How to Compute Days Sales Receivables Important to my Business?

Days Sales Receivables (DSR) is an efficiency metric for determining how quickly a business is able to convert a receivable into cash.  Sometimes it is referred to as Days Sales Outstanding or DSO.  In either case, it is the same business metric.

Since cash is king, the faster a business is able to convert a receivable into cash, the better.  Essentially, a receivable is created when a business extends credit to a customer.  Some businesses do not need to extend credit at all, and consequently have $0 receivables.  For example, McDonalds does not extend credit when you purchase a cheese burger.  You give them the cash and you get your cheese burger.  If you were to look at McDonalds SEC filings and review the level of receivables on their publicly listed balance sheet, you would see a very small number given their revenue size. 

Learn how to compute days sales receivables, or commonly know as DSR, and learn ways to utilize this valuable metric to improve cash flow. Click to Tweet

Most businesses have to extend credit to their customers.  For example, if you sell products to retail stores as a wholesaler, then you are going to have to extend credit to your customers.  If you were able to negotiate 30-day terms with all your customers and they precisely paid in 30 days, then your DSR would be 30 days.  In reality, no business collects in precisely the number of days they negotiate with their customers and generally the resulting DSR is worse than what is negotiated for various reasons.  But you want to pay particularly close attention to your business’ overall DSR performance to ensure it does not drift upward, or if does drift upward you understand the circumstances and have someone “bird dogging” customers for payment as well as enforcing credit holds when merited.  As a CFO Services firm to midsize businesses, we frequently see business owners ignoring their overall DSR trends until they have a significant liquidity problem that could have been prevented by more diligently monitoring their metrics. 

How to Compute “Days Sales Receivables”

DSR like most financial metrics is retrospective in that you have to use historical business activity to compute the current month metric.  There are basically two methods: 1) the look back method; and 2) the rolling 12-month method.  I made up the name of the second method, because I am not sure if it has an actual name, but it is the more commonly used.  This is because it is much easier to implement the rolling 12-month method in a spread sheet vs. the look back method.  We will start with the look back method.    

Computing DSR Using the Look Back Method

In either methodology, you start with the month-ending accounts receivable balance for a business.  Though both methods given fairly similar results, the look back method is more well suited for monitoring DSR at a more granular level.  For example, you would probably want to use the look back method if you were a construction firm and needed to understand DSR at a customer level.  In summary, you start with the month-end receivable balance and you begin subtracting the monthly sales from the outstanding receivables balance, adding the calendar days from each month, until you go back far enough to bring the balance to $0.  Typically you end up having to prorate the final month.

DSR calculation example using look back method

The example above reflects a single customer (Customer XYZ), with a month-end October receivable balance totaling $450K.  On the next row you can see the monthly invoicing to this customer.  To compute the DSR, we work backwards beginning with October 2021, by subtracting the monthly invoicing from the month-end October receivable balance, accumulating the days in each month.  Starting in October, with a $450K balance, we subtract the October 2021 invoicing (invoicing equates to monthly sales) and get a balance of $375K.  We then subtract the $375K balance from the $43K September invoicing to get $332K.  This goes on until we get to $0K remaining receivables which happens in March.

The invoicing in March is greater than the $73K remaining balance from April; consequently we do not add the full 31 calendars for March, but prorate the 31 days.  The March days are prorated by dividing the remaining balance ($73K) by the total March invoicing ($80K) and multiplying that fraction by the number of calendar days in March (31) or $73K Remaining / $80K Total Mar Invoicing * 31 Days = 28 Prorate Days for March.  Then we add the days for March through October and get 242 Days Sales Receivable.  This is huge DSR and indicates that the business have 242 days worth of invoicing extended as credit to this customer or about (242 Days / 30 Days Per Month) 8 months of work. 

As you can surmise, using the look back method is a little complicated.  But it does provide accurate DSR metrics when looking at an individual customer or in situations where invoicing/revenue is lumpy throughout the year.  To easily implement the look back methodology, you will need a custom function macro.  Contact us if you would like a copy of the function macro to perform this calculation.  If your revenue tends to be relatively consistent, then you want to use the rolling 12-month methodology.

Computing DSR Using the Rolling 12-Month Method

As mentioned earlier, the rolling 12-month method is much easier to implement in a spreadsheet application.  The method works well for businesses that have fairly stable revenue, with multiple customers.  Here is an example of the rolling 12-month method:

Example of computing DSR using the 12-month rolling methodology.

In this example, we have hidden the April through August columns for brevity.  Here we are computing the DSR for ME December 2021.  Since this is a 12-month rolling method, we accumulate the prior 12 months of sales, which was $12,685K.  Then we need to compute the average daily sales, which is $12,685K / 365 Days = $34.75K per day.  Now that we know what the average per day sales equates to, we just need to divide the month-end December receivables balance by this factor to determine that we have 46 days of receivables currently (or $1,585K / ($12,685K / 365 Days) = 46 DSR). 

The following month, we would divide the January 2022 month-end receivable balance by the 12-month average daily sales, which would include sales for February 2021 through January 2022, and so on and so forth.

Gaining Actionable Intelligence Regarding DSR

The first step is gaining actionable intelligence is to put together a time phased financial plan that includes a forecast for both revenue and receivables.  The starting point for this exercise would start with computing the DSR trends for the previous year to gain a good understanding of collection effectiveness.  Using the prior year trend as a baseline, you can develop a generalized plan as to the DSR target.  With the DSR target in hand as well as the revenue projection, you can back into the receivables plan. 

Graphical Trend of DSR for 2020

This is a good template for tracking receivables.  You can see that on the left Y axis we are measuring monthly dollars of receivables.  On the right Y axis we are measuring the DSR.  The 2018 and 2019 year-end total receivables and DSR values are posted for reference.  The 2018 ending DSR was 52 (see the yellow dot with the 52 below it) and 2019 ending was 51 days.  The total receivables dollars increased from 2018 to 2019, from $1.5M (see the bottom of the column) in 2018 to $1.9M in 2019, while the net DSR decreased a day.  This occurred because 2019 sales were 20% higher than in 2018.  This is a good example where you cannot just look at the total receivables to figure out how efficiently you are collecting receivables. 

You can also see that sales have been strong in 1Q 2020 and collections through February have deteriorated to 63 days of receivables on the balance sheet.  Now is a good time to take a deeper dive into collections to better understand what is driving this increase to make sure there are no major issues.  Using a tool similar to the above display helps business owners know when to dig into the detail and when to just tweak business processes, such as the number of days of credit extended to new customers, to affect cash flow.

Benchmarking and It’s Relevance to Managing DSR

Benchmarking is essentially the process of comparing a company’s financial metrics against an industry cohort of similar size.  There are a number of places to get industry cohort metrics, one of which is the Almanac of Business and Industrial Financial Ratios, written by Leo Troy, Ph.D. and published by CCH. 

We have posted a copy of the page that relates to the this business below.  The columns relate to the asset level with the industry group.  For our company referenced above, the Receivables Turnover metric was 14.9x.  To convert the Turnover to DSR we have to divide the number of days by the Turnover 365 Days / 14.9x = 24 Days.  Given that our business DSR is in the low 50 days, this would indicate that other businesses within this industry are doing much better.

Benchmark Almanac

The 24 Day DSR more than likely requires more research.  The cohort businesses may have a greater level of cash sales than our example company.  But if our example company were able to achieve a DSR at 24 days, the Receivables would be cut in half increasing cash flow about $1.2M.  Benchmarking is helpful, but the key is continuous improvement.  The business ended 2019 at 51 days, which is better than 2018.  With resources, the business should attempt to bring the DSR closer to 45 days by implementing strategies with key customers.

Final Comments on Days Sales Receivables

Managing receivables effectively is a management imperative for all businesses that extend credit.  Your ability to management this important asset will be the difference between a business owner being a prince or a pauper.  Learn the basics.  Set up metrics so that you can monitor monthly changes in efficiency, such as the graph displayed above, and ask probing questions when trends are going in the wrong direction.  At least quarterly, go through the sub-ledger details with your accounting staff and identify actions for improving collections and write offs.  If you need a copy of the look back method Excel function macro, please contact us.

 

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.