Cash Is Crucial (Part 2): How to Prevent Anxiety-Inducing Cash Crunches
In the first blog post in this series we met Thirsty, Inc., a profitable beverage distributor that found itself in a tough situation.
Here’s a quick refresher:
Thirsty, Inc. had purchased a popular new beverage called Ice Cold from their suppliers
Thirsty, Inc. quickly sold out of Ice Cold and wanted to order more, but they didn’t have the cash available
What Can Thirsty, Inc. Do?
If you were the owner, how would you get yourself out of this predicament? Your mind starts racing with possibilities: call customers to see if they can pay early, contact your bank for a line of credit, contact suppliers to see if they’ll extend their terms. While these options are good short-term solutions (if they are successful), they won’t necessarily prevent you from finding yourself in a cash crunch in the future.
What should Thirsty, Inc. do? They need to improve their cash conversion cycle! Say what?! The cash conversion cycle (CCC) is just a fancy name for how quickly a business can convert cash in their bank account to profits in hand. See the graphic below:
Generally speaking, a lower CCC number indicates Thirsty, Inc. is more efficient and effective with their cash management. Our goal is to improve the CCC for Thirsty, Inc., helping them achieve a lower CCC number to prevent cash crunches in the future.
There are three components to the CCC calculation:
# of days to sell inventory (you want to reduce this, but not so low you are consistently running out of stock)
# of days to collect on sales (you want to reduce this)
# of days that payables are outstanding (you want to increase this, but not by paying vendors late)
We will look at each of these factors for Thirsty, Inc.
Number of Days to Sell Inventory
A key factor that I haven’t mentioned yet is the number of days inventory sits in Thirsty, Inc.’s warehouse. Most companies aren’t so fortunate as to turn inventory immediately once it is received from their suppliers, so we should probably assume Thirsty, Inc.’s inventory sits in their warehouse for some period of time prior to being sold. The longer it takes for them to ship goods to customers after they are purchased from suppliers, the greater the impact it will have on the CCC number, pushing this higher.
In this example, we should determine how long the Ice Cold (and other products) sit in the warehouse before being shipped to customers. It’s quite possible that Thirsty, Inc. got excited, ordered a bunch of Ice Cold and then had to wait several weeks before it sold as they marketed the new product to customers. Or maybe the Ice Cold moved quickly, but Thirsty, Inc. is always ordering the latest new sodas to entice customers, which don’t always sell – like Pepsi White or Ranch Dressing Soda. Issues such as these will increase the number of days to sell inventory and increase their CCC.
There are several ways to reduce the number of days to sell inventory, to name a few: pare down slow-moving inventory, improve sales forecasts to aid purchasing decisions, and work with suppliers to decrease lead times. There are other ways to improve this metric, but whichever means you choose, none of them are a one-time silver bullet. Monitoring your CCC is an ongoing adventure!
Number of Days to Collect on Sales
Another key factor to consider is the number of days to collect on sales. After the inventory left Thirsty, Inc.’s warehouse, payments weren’t due from their customers for 45 days! Extending these generous payment terms to customers may make the customers happy, but it really hurts Thirsty, Inc.’s cash flow.
You can focus on improving your days to collect on sales by negotiating shorter payment terms with customers, offering an ACH payment option to eliminate postal days when receiving payment, evaluating your current customer AR aging report to weed out slow-paying customers, or by working with your AR department to improve collection strategies. Of course, there are always complicating factors to consider. What are typical payment terms in the industry? If Thirsty, Inc.’s competitors offer 45 days for payment, it may be challenging to get customers to agree to a quicker turnaround. All options should be considered.
Number of Days That Payables Are Outstanding
The longer a company can wait to pay their vendors, the longer it can hold on to cash and reduce its CCC. Right now Thirsty, Inc. needs to pay its supplier of Ice Cold in 15 days, which is much shorter than the 45 day payment terms it extends to its customers. To increase days that payables are outstanding, Thirsty, Inc. can try to negotiate longer payment terms with their supplier or pay with a company purchasing card (credit card). It is also important to look at the terms they have with all their suppliers and when they pay them. Perhaps some of their suppliers demand payment in 7 days or maybe Thirsty, Inc. is paying all their suppliers when they receive the product, prior to when the payable is due. Prolonging payment could help ease the cash crunch, as long as they ensure sufficient funds are available when payment is due and they aren’t paying suppliers late.
What Is the Best CCC Number?
Is there a magic CCC number we should have in mind? The short answer is no. Many companies benchmark their CCC number against industry competitors. What is perhaps most useful is to monitor your company’s CCC number over time to see how it correlates with your available cash to satisfy your company’s needs. For example, let’s assume after this cash crunch Thirsty, Inc. starts calculating their CCC quarterly. They notice their CCC is consistent and realize they are also consistently facing the growing pains of not having enough cash to fuel their growth – it wasn’t just a one-time incident with Ice Cold. After seeing this trend, Thirsty Inc. knows they must take a proactive approach to managing their CCC to prevent future cash crunches and fuel their continued growth. This is a great idea!
Managing the CCC at Your Company
When you devise your strategy, think back to the three variables in the CCC formula: days to sell inventory, days to collect on sales, and days that payables are outstanding.
Whatever option(s) work best for your company, set goals and stick to them. Continue to monitor your CCC on a consistent basis to see if it is trending toward improvement. Remember, this is usually a marathon, not a sprint; don’t get discouraged at setbacks along the way! What’s the next step after you recognize your CCC is trending in the desired direction? Take a close look at your cash account and purchasing. Holding all else constant, you should consistently have more cash available for purchasing now vs. when your CCC was much slower.
In our next part of this series, we’ll review strategies on how to analyze inventory performance, a key component of the cash conversion cycle.