Last week I wrote about the early yardage predictor of cash-flow.
Do you remember? It is the estimated dollar figure of what is in your sales pipeline. And there is the timing aspect. This is the time it takes from connecting with a prospect to closing a sale.
This week we will look at what I call the back-end timing.
Now we look to the future. We look at one grand Key Performance Indicator. It is made up of 3 parts.
Let us take a look at…
What is Your Cash Conversion Cycle?
In a perfect business you have no accounts receivable, no inventory, and you pay your vendors later!
This translates to – you make a sale, and the cash goes into your bank right away.
Imagine you pay your suppliers in 30 days. Wow! Perfect, right? You get the money right away and pay your vendors later.
For most businesses, this is not how it works.
Because for most businesses, you have accounts receivable, inventory to sell and accounts payable to pay.
Most businesses have money tied up in accounts receivable (money owed to you). Then there is a lot of cash invested in inventory for others.
The third number is favorable to you – paying your vendors later helps preserve cash!
Let us take a look now at what makes up the calculation of your cash conversion cycle…
Cash Conversion is Made Up of 3 Numbers
Three things make up your cash conversion cycle:
- The days on average it takes to collect your accounts receivable, plus,
- The days on average it takes to sell your inventory
- Less the days on average you take to pay vendors
Let us say it takes you an average of 27 days to collect your accounts receivable (amounts owed to you).
It also takes an average of 18 days to sell your inventory on hand.
You take 21 days to pay your vendors.
Your cash conversion cycle is simply the sum of the first two numbers less the 3rd number.
In this example, you add 27 days to 18 days, and you get 45 days. You subtract 21 days that you take to pay your vendors for the final number of 24 days.
Your cash conversion cycle is 24 days.
This is an estimated number and not a hard number. Each number is an average and it is based on the past.
Anything changes and boom, so does the number.
What Should Your Goal Be?
The trick to improve your cash conversion cycle is to get paid quicker from your customers, sell your stock on hand faster, and pay your vendors a bit more slowly.
Here is an interesting question…
Can you ever have a negative cash conversion cycle?
Here, “negative” is great!
For instance, you get paid upfront for most sales, so your Days Receivable is just 3 days. You turn your inventory over super fast in 9 days. You pay your suppliers in 21 days.
So, let us do the math. Three plus nine equals twelve. Twelve minus twenty-one equals what? Negative 9.
This would be a ridiculously awesome business to have, provided it is profitable. It would always be cash-flow positive!
Thanks for reading…