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Powerful Game Changing Ratio to Monitor in Tough Times

An often-overlooked ratio to track is a combination of three other ratios…

Once you calculate the other three you simply add the three to get this Turbo Ratio that I recommend all businesses with accounts receivable and inventory track.

So, what is it called?

It is called…

Your Cash Conversion Cycle

It is the measurement of how many days on average it is taking your company to convert sales into cash.

It is the combination of three separate ratios:

  1. Days Receivable – the number of days on average it takes to collect your accounts receivable.
  2. Days Inventory – the number of days on average it takes to sell your inventory.
  3. Days Payable – the number of days on average you take to pay your bills.

Let us go through each of these three ratios…

Your Days Receivable

Here the lower the number of days the faster you are converting your receivables in cash.

You need the following numbers to calculate your days receivable ratio:

  1. Opening balance of your accounts receivable, at the beginning of the month
  2. Closing balance of your accounts receivable at the end of the month
  3. Your monthly sales on credit (non-cash sales)

Add your opening accounts receivable balance to your closing accounts receivable balance and divide by 2.

Take that number and divide by your total credit sales for the month.

Multiply that number by the number of days in the month.

Accounts receivable opening balance = $100,000

Accounts receivable closing balance = $200,000

Average accounts receivable balance = ($100,000 + $200,000)/2 = $150,000

Sales for the month = $300,000

Days in the month = 30

$150,000/$300,000 x 30 = 15 days

Now let us look at the next ratio…

Your Days Inventory

Here as well, a lower number of days is better for your cash-flow.

You need the following numbers to calculate your Days Inventory ratio:

  1. Opening balance of your inventory, at the beginning of the month
  2. Closing balance of your inventory, at the end of the month
  3. Your Cost of Goods Sold for the month.

Add your opening inventory balance to your closing inventory balance and divide by 2.

Take that number and divide by your total Cost of Goods Sold for the month.

Multiply that number by the number of days in the month.

Inventory opening balance = $300,000

Inventory closing balance = $600,000

Average inventory balance = ($300,000 + $600,000)/2 = $450,000

Cost of Goods Sold for the month = $750,000

Days in the month = 30

$450,000/$750,000 x 30 = 18 days

On average it is taking you 18 days to turn your inventory over. In other words, to sell it.

Now let us look at the next ratio…

Your Days Payable

For this ratio, a higher number is better! Why? Because you are taking longer (i.e. more days) to pay your bills on average which means you are preserving cash for a longer period.

You need the following numbers to calculate your days payable ratio:

  1. Opening balance of your accounts payable, at the beginning of the month
  2. Closing balance of your accounts payable at the end of the month
  3. Your monthly Cost of Goods Sold

Add your opening accounts payable balance to your closing accounts payable balance and divide by 2.

Take that number and divide by your total Cost of Goods Sold for the month.

Multiply that number by the number of days in the month.

Accounts payable opening balance = $250,000

Accounts payable closing balance = $350,000

Average accounts payable balance = ($250,000 + $350,000)/2 = $300,000

Cost of goods sold for the month = $900,000

Days in the month = 10

$300,000/$900,000 x 30 = 10 days

Now, let us put it al together…

Your Cash Conversion Cycle

The formula for your cash conversion cycle is:

  1. Days receivable
  2. Days inventory
  3. Less – Days payable

Using our numbers from above we have:

Days receivable = 15 days

Days inventory = 18 days

Days payable = 10 days

Your Cash Conversion Cycle is 15 plus18 minus 10=23 days

Although this is a very crude measurement what it tells you is that on average you will convert your sales into cash in about 23 days.

In Closing

Remember the lower the number the better. Why? Intuitively you will want to convert accounts receivable and inventory to cash as quickly as possible. Less days to do so means cash is hitting your bank account more rapidly.

One other thing to keep in mind is that the Days payable number is more beneficial the higher it is! That is why it is subtracted in the Cash Conversion Cycle Formula.

The longer you take to pay your bills the more cash you have available to run your business. Here you will want to operate with integrity and not take too long to pay your suppliers. After all, they are essentially your partners in your business.

That said, it is fair if you take advantage of longer payment terms and wait as long as possible to pay.

Thank you for reading….

 

 

 

Five Reasons to – Finally – Stop Printing Cheques

Cheques are becoming less common now. But not uncommon enough. Here are 5 reasons to wean your business from the cheque addiction (for those still afflicted) …

Reason No. 1 – Con Artists

Cheque fraud is bigger than online fraud by a country mile. A cheque circulates in physical reality. Thieves can acid wash your cheque, print their name on it, and cash it.

Reason No. 2 – Cost

The Canadian online bill payment service we use is inexpensive. Yet I have had business owners balk at the price. It is about $1.50 per payment for 20 payments.

A stamp is $1.07 now. Then there is the paper and envelope.

How about the time to print, get a signature or two, and stuff the envelope?

Then your bookkeeper has to record that cheque in the accounting system.

This adds up to $20 or more per cheque.

Check out this article on the true costs of cheques:

The Hidden Cost of Check Payments

Reason No. 3 – Convenience

When you need two signatures, and one person is away what do you do?

Mail it from person to person? Yikes! With Canada Post that could take weeks. Courier? Please see reason 2 above. 

Some people pre-sign cheques when they will be away to avoid this problem. This opens up fraud. Please see reason 1 above.

Reason No. 4 – Covid

With Covid, the rules of engagement have changed. Your office may be closed. Where are the cheques? Can your bookkeeper get into the office? Yes?

Great! How about the signers? Both of them? Are all three working from the same office?

You get my point…

Reason No. 5 – Controls

With a solid online bill payment service, you set an accounts payable approval matrix. Vendor bills can be routed to as many people as you like, working from as many places as you can imagine.

This makes for a great audit trail. You can see each person who approved the payment.

Oh, and a really cool feature – you can see the actual vendor bill attached for easy reference!

So, what are you waiting for?

Want to know what we use? Kindly email me, and I will let you know…

3 Reasons to Stop Writing Cheques

When was the last time you wrote a cheque?

For me, I cannot remember. I have an ancient box of business cheques somewhere in my office, collecting mold. They are so old that the address is incorrect.

Think of it, dear reader, it is Covid 19 times. You are a mid-sized business. Perhaps multiple locations. Cheques need to be signed by at least two people.

The problem is hardly anyone is working at the office anymore.

What do you do? Sign the cheque and mail it to the next signer? Yikes!

This is just so wrong.

The Entire Cheque Cycle is Slow

That cheque, with one signature, is now in the physical Canada Post eco-system.

How long will it take to get to second signer? And then to the supplier? A week? 10 days? Two weeks? Oh my.

But wait! You have solution! Just pre-sign a stack of cheques and leave them with second co-signer. That will solve the problem, right?

Some of you may be either laughing (thinking of the obvious – the controls of 2 signatures have just been broken). Others, are thinking, “would anyone actually do that?”

It is done all the time.

Never Pre-Sign Cheques

A company we knew had the business owner pre-sign a stack of cheques for the bookkeeper to pay bills.

They were kept in the safe. “Safety first”, correct?

The bookkeeper had a new baby. The costs of giving her sweet baby everything she deserved was high. Toys are expensive on a bookkeeper’s salary.

These signed, blank cheques were sitting there, a severe temptation. Like wine in the fridge to an alcoholic.

Would the owner even notice if a few cheques ended up supplementing her low wage?

She secretly filled out some cheques payable to her credit card, not the owner’s. This went on for years.

She coded the “expense” to inventory. (Perhaps she was thinking how fitting – inventory of toys and things for her baby).

The owner never discovered the fraud. Finally, (and this is usually how these things are revealed), she took a holiday. The relief bookkeeper could not reconcile the bank. She got suspicious, and uncovered the fraud.

The morale of this story is – never pre-sign cheques.

Why Do You Trust the Physical and Not the Virtual?

When a signed cheque leaves your office, it can be intercepted.

Think of all the stops along the way. Your office (before it is mailed). The mailbox. The routing stations at Canada Post. The office where it is being sent to.

It is a crap shoot.

Cheques intercepted are acid washed. The payee changed. You would not recognize your signed cheque when you see it.

Compare This to an Online System

We use a Canadian company called Plooto for online bill payments.

Bills approved for payment in the accounting software are synced to Plooto. The source documents move with the bill.

Inside Plooto you can set a simple or complex payment approval matrix.

Payment approvals can be set to require multiple approvals. Dollar amounts can be set so that the owner is not having to sign everything.

Everything is approved virtually, online.

There is an audit trail.

The payments go through the Canadian payments approval process, just like a cheque would.

The supplier can receive the payment via email. They log into their bank using their own bank credentials and deposit the money you are sending.

Some Interesting Stats

Australia has virtually eliminated cheques. The banks charge about $50 to process a cheque. Not much of an incentive to use cheques!

The overall numbers are interesting – 5% of payments are paid by cheque in Australia.

In Canada?

In 2019, 39.38% of all payments were by cheque. If you remove personal payments, the business cheques are significantly higher.

My coaching – stop writing cheques.

You will save time, money, and reduce risk of fraud.

And in Covid 19 times, online bill payments just make sense!