Cash Conversion Cycle: Demystifying a Crucial Business Metric
There are quite a few financial measures that you, as a business owner, would need to keep an eye on to run a profitable business such as a profit and loss statement, a balance sheet, and possibly a cash flow statement. This will give a snapshot of where the business is at. While you’re probably on top of metrics such as cash flow and sales projections, you may not be as diligent in monitoring your cash conversion cycle.
So, what is a Cash Conversion Cycle (CCC)? Let’s consider a situation to understand this methodology- your business is offering services to a client and you’ve got somebody in your business looking after that client for a month, you’ll pay them a salary for that month and on the other end, you will bill your client. And if your client then takes 30 days to pay you, and you’re still servicing them. You have a payroll for two months before you’ve been paid for one month. Basically, by the time you get the cashback out into your bank account, you already have one month outstanding of all payroll and that’s how your money is stuck in the system.
This gap is what a CCC will help you measure. How long does it take your business to convert cash into inventory, then into sales, and finally back into cash again? In essence, it helps you to audit your own business, in a way, where you know where the cash is stuck, which can be released, and made available for you to fund your business or your business growth.
When you were taught about finance or in commerce when you were taught about what happens within the business that’s only half the picture. The other half of the picture is when you actually go deeper to see what the various cycles are, and how is cash flowing through them. The CCC is more of a ‘how to’ tool. How to calculate the cash by figuring out how long it takes you to sell inventory, how long it takes you to collect your accounts receivable, and how soon you can pay your accounts payable.
There are 4 Focus Areas in the Cash Conversion Cycle
First key area to focus on is your Sales Cycle. So, you have a sales and marketing team and there is a system in place or pipeline from talking to your potential customer to converting them into your client. First question to crack here is, can you shorten your sales cycle? Perhaps talk to your customers and prequalify them sooner, get them on board, and get to where you’re working with them sooner.
Now the second key area of focus is when you have a physical product, that you are trading or you’re actually manufacturing a product then you consider the manufacturing cycle which then becomes inventory because it includes an inventory of your raw materials.
If it’s a trading business then it includes the actual stock that you’re holding. Before it is sold and sent to the customers, you would take into account the logistics that go with it and how efficiently the process runs, which then leads nicely into the third cycle.
The delivery cycle. This cycle specifically plays a crucial role in a service business. With a service business, depending on how you put that together, you can actually productise your business. Most service businesses think that they are selling a service, not a product, and almost an equal number of businesses today actually productise their service. Consider the design and pricing of that as a product. Bending on a slightly different curve over here, but the point of addressing that is, every time somebody sells a service, please think of it as you are selling a product, it doesn’t always have to be a physical item that you’re selling, so productise your service.
Now, we come to the fourth cycle which is the one, most businesses focus on, that is your billing and payment. When you look at the profit and loss statement and you see you have made a profit, that’s great! Although after you do the billing, you realize you are still waiting for people to pay. Now that’s the one because it’s now in front of you and people are paying attention to it, forgetting that the delivery cycle, the manufacturing cycle, and your sales cycle beforehand, all suck cash. That’s where your focus should be and there are several ways you can even shorten the payment or the time to get the money, and that’s either through your terms, or maybe credit cards, if you’re okay with a little percentage going away in the collection, you will get your money sooner.
How to Sustainably Shorten Your Cash Conversion Cycle
One of the first places to make changes to shorten the CCC is by requesting quicker payment terms from a big supplier, it might bill in advance, for example.
Similarly, ramping up cash collections from customers will help improve the gap too. Remember if somebody is paying late, put on your coach’s hat and have a conversation with them, understand their payment cycle, understand if there’s something that you could do better. Because at the end of the day, a good relationship will generally get a quicker payment.
To sum it up, revisiting payment terms with customers and suppliers is an essential part of improving your cash conversion cycle. However, they should be optimized gradually over time rather than used as a short-term improvisation.
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Key Takeaways and Benefits of Using a Cash Conversion Cycle
Understanding a company’s CCC can help regulate its efficiency. A lower cash CCC is usually a positive sign that the company is running well and meeting the needs of its suppliers and customers. More importantly, it indicates it has a good amount of liquidity which is an imperative part of making a profit.
Now that we have covered up the four big levers, if you will, within the Cash Conversion Cycle, go through your own business and assess the cycles that exist over there, audit them and see, where can these cycles be shortened, then how does cash flow or how and where does cash get stuck in your business by assessing and removing mistakes, improving processes which include tweaking your business model, which then leads to internal profitability of product lines.
All of which will help produce more cash and get you to receive it quicker. That’s the aim because remember “Cash is king” and if your business is growing or you are on the path of scaling up. What will you need first? A plan? Yes! and before that? Always CASH. You need cash in your bank account to be able to grow. And the point is to grow organically, without getting unnecessary external funding sources.
Internally cash is coming in, that velocity is increased, and you can grow organically and efficiently. You really can hit the ground running. On that note that’s your Cash Conversion Cycle. Remember, identifying and shortening the gaps where your cash gets stuck is the name of the game. Have a look at your business, come back, and share with us how it went!
