Last week I talked about the difference between cash and profit.

This week, we’re going deeper into cash flow and a nifty little metric called the cash conversion cycle.

All businesses need to understand the flow of cash in their business, but it’s complicated.

Let that be an excuse no more.

With the economy and uncertainty looming ahead, it’s more important than ever that you tackle the beast that is cash flow.

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Gamifying Cash Management in Your Business

Cash is the lifeblood of any business.

In last week’s newsletter we talked about the difference between profit and cash. If you missed it, you can read it by clicking here.

I ended by saying that the ideal business would have:

• Favorable terms on inventory
• Customers paying immediately
• Little or no reinvestment is needed in the business

When these 3 factors are work in your favor, your cash (generated from profits) becomes available to you much sooner.

By using the cash conversion cycle, we can calculate the number of days between purchase of inventory and ultimately receiving the cash from the customer.

It is broken down into:

CCC = DIO+DSO−DPO

DIO = Days of inventory outstanding (days to sell inventory)

DSO = Days sales outstanding (days to collect money from customers)

DPO = Days payables outstanding (days to pay the bills)

Before we go into each of these formulas (because what’s better than 1 formula? 3 formulas-in-one!!!), let’s use our example from last week to talk about each element.

If you remember, in Scenario A we:

1. bought and paid for our inventory on the same day
2. held the inventory for 10 days before sold
3. were paid 30 days after sale

Looking at the elements of CCC, we plug in the values:

DIO = 5 Days of inventory outstanding

DSO = 30 Days of sales outstanding

DPO = 0 Days payables outstanding

So, our CCC = 5 + 30 - 0 = 35 days

In Scenario B the customer has to pay when they buy, which takes DSO from 30 to 0.

So, our CCC = 5 + 0 - 0 = 5 days

Pretty, pretty good!

In Scenario C we get 30-day terms on the inventory, which takes DPO from 0 to 30.

So, our CCC = 5 + 0 - 30 = NEGATIVE 25 days

That means we can use the revenue from the sale to actually pay for the inventory we purchased.

Assuming we can keep that up, a negative CCC allows you to keep buying inventory and scaling.

When you start to understand the cycle, you can start to look for ways to “game” each element.

• How can you decrease the time you hold inventory?
• How can you collect money faster from your customers?
• How can delay your payment (ethically) to the vendor?

Let’s go through each element, talk about how to calculate it, and analyze our options.

DIO = Days of inventory outstanding (days to sell inventory)

DIO = Average Inventory / Cost of Goods Sold (COGS) x 365 days

A high DIO means inventory is not getting sold quickly, which can be from overstocking or a slowing of sales.

Improve (by decreasing it) your DIO by:

• Refining your inventory forecasting
• Order in smaller quantities, but more frequently
• Improve inventory tracking and management once onsite
• Getting rid of slower-moving and lower margin products
• Starting a marketing initiative that increases demand

But, don’t improve it too much, as a DIO that’s too low can also put stress on your operations. Look at industry averages and understand where you are in comparison to your peers.

DSO = Days sales outstanding

DSO = Account Receivables / Sales x 365 days

This tells you how quickly customers are paying what they owe you.

A high DSO (> 45 days) means you’re not collecting your money and could be a sign of bad processes.

To improve your DSO:

• Create or improve your customer credit evaluation process
• Shorten the time between delivery and invoice creation
• Manage your accounts receivable proactively
• Reduce customer payment terms
• Accept more forms of payment
• Offer early-pay discounts
• Ditch late payers

Different industries, types, and size of customers pay in very different ways. Be careful doing business with big corporations as the small guy, because it’s very easy to lose control of your ability to get paid.

DPO=Days payables outstanding

DPO = Account Payables / COGS x 365 days

This tells you how quickly you pay suppliers.

An increasing DPO means you’re slowing down payment, which can be good or bad depending on WHY. If you’re slowing down to intentionally improve your CCC, fine. But if you’re slowing down because of cash flow problems and start paying people late, this is a big cause for concern.

You’ll notice this includes all payables, not just inventory-related payables. You’re not just limited to the sales cycle, as you can reevaluate how you pay ALL your vendors.

To improve your DPO:

• Pay your bills no earlier than 7 days before the due date
• Pay invoices (at due date) on credit cards, extending terms another 30-45 days
• Negotiate better terms with your suppliers
• Reduce your cost of goods sold

How does it work for Services?

If you’re in a service-based business that doesn’t have inventory, you can replace DIO with service delivery to invoice (or notice to customer).

Do the work on October 4th but don’t invoice until the 31st? That’s a 27 day “DIO” that could be improved.

If the service delivery is an employee hour, you can also replace DPO with the employee’s payroll date.

Work done: 10/4/22

Payroll ran: 10/14/22

Invoice created: 10/31/22

Payment received: 11/30/22

Using the CCC concept, your CCC would be 47 days (27+ 30 - 10) or the difference between 10/14/22 and 11/30/22.

Wrapping Up

Understanding your cash conversion cycle is essential to understanding your cash flow.

When tracking it, watch the overall trend and trends by each variable.

Start improving your CCC by:

• documenting your process from start to finish

• ask questions of each step, one-by-one

I find it’s a good practice to review your whole cycle at least annually.

If you have any issues, or questions, don’t hesitate to reach out.

Things of Interest

We spend a lot of time talking about real costs in your business, but recently we’ve talked about some of the hidden costs.

In my latest podcast, I break down opportunity cost and sunk cost and how awareness is key in making sure we account for these hidden costs in our decision-making processes.

Listen Now

Thank you for reading–see you again next week.

If you’re interested in learning more, here are 3 ways I can help:

1. ​Purchase the Financial Statements Decoded eBook.
2. ​Join the waitlist for my cohort Financial Statements Decoded. Next one is in January!
3. ​Work with me 1-on-1 to optimize your financials and create a financial dashboard that will increase profit (booked through November 2022).