The cash conversion cycle measures how effectively a company collects its cash. When looking at how a company does this, we first have consider how fast a company decides to pay the money it owes its vendors.
Accounts payable is a tough figure to get right. It’s an area where finance meets philosophy. Financial considerations alone would encourage business owners to maximize days payable outstanding (DPO), thereby conserving their company’s cash. Any kind of change in this ratio can have ripple effects on other ratios, such as inventory and cash balance.
This is where it gets tricky because you have to consider what kind of relationship you’re going to have with your vendors. What kind of reputation do you want?
In a practical sense, how much leverage do you have with your vendors? Will they even continue doing business with your company if it is a late payer? Plus, if you pay on time, are there any benefits? Tangible or intangible? Goodwill goes a long way if you ever have to renegotiate a contract.
There’s also the consideration of the Dunn & Bradstreet ratings 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.
For example, let’s say Josh has a company, Micropoint. He never let an invoice go beyond thirty days. the company’s philosophy is that slow payments simply aren’t good business. Where exactly did that philosophy come from?
When Josh’s co-founders, both engineers, started Micropoint, they had recently left another company. They had been project managers, designing custom products for the company’s customers. But when they sent their designs out to be fabricated, no one 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 turn, 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, the company founders believe that it positively affects the company’s reputation and relationship with its vendors — and in the long term helps the company build a stronger community of businesses around itself.
Start asking questions if you notice that your company’s days payable outstanding (DPO) is climbing. Especially if it is higher than your days sales outstanding (DSO). Part of success for a company depends on good relationships with its vendors.
The Cash Conversion Cycle
Do you know how many steps it takes for you to monetize?
Cash conversion is essentially a timeline relating to the stages of production verses the company’s working capital. Understanding the multiple levels and how they are linked provides a powerful way of understanding your business and should help you make financially sound decisions.
Starting from the left, the company purchases raw materials, which begins the accounts payable period along with the inventory period.
Next, the company has to pay for those materials, so the objective now is to recoup those costs. How fast can they create a finished product? How many steps do they have before they actually monetize? Remember, nothing happens until something is sold.
The company is operating at this point from a deficit. Eventually the company sells the finished goods, ending the inventory period and transitioning into the accounts receivable period. However until they actually receive some cash from the sale, they don’t get to end the cycle in accounts receivable.
Why is this so important? Because over time, we can actually measure how many days it takes to complete a cycle. We can understand how the company’s cash is tied up. It also yields insight into what an entrepreneur can do to “save” cash. The formula for understanding the process is:
We take days sales outstanding, add days in inventory and subtract the number of days payable outstanding. This 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.
It tells you how much cash you need to keep the business up and running smoothly.