Have you ever imagined yourself rolling around on a bed full of money? For entrepreneurs, an even sexier version of that fantasy is having all that cash available to spend on growing their business. I’m going to tell you how optimizing your cash conversion cycle can make this fantasy come true.
If I were to ask you how your business is doing, what metrics would you use to inform your answer? If you’re like many entrepreneurs, I’d bet that you’ll look at your profit and loss statement, your revenue numbers, and maybe even your margin.
If you’re savvier than most entrepreneurs, you’ll look at your cash flow. We’ve talked before about the importance of cash flow (including the 7 deadly sins of cash flow management). Ultimately, managing your business is more a question of cash flow and less about your balance sheet.
You’ve got to have the right amount of cash coming in and the right amount of cash going out. Otherwise, you’re in trouble. The cash conversion cycle is a concept that can help.
What is the Cash Conversion Cycle?
The cash conversion cycle is a simple way of understanding the time from when you start spending money to when the resulting revenue comes in the door. There are normally four stages in the cash conversion cycle:
- Billing and collection
If you want to optimize your cash flow (and trust me, you do!), the best way to do so is to reduce your cash conversion cycle to make it as short as possible.
Cash Conversion Cycle: The Classic Mistake
One of our clients is in the manufacturing business. To save money (or so they thought), they decided to buy large batches of their raw materials. Their suppliers were happy to give them a great discount because they were buying a big batch in advance. That sounds like a no-brainer, right? Well…maybe not.
You might think it’s a priority to get a good deal, but they were making a classic mistake when it comes to the cash conversion cycle: they started spending money several months before they would have any money coming in from sales. In simple terms, they had cash going out hundreds of days before they had cash coming in (uh oh).
With all these raw materials, this company would do larger production batches and make a lot more inventory. And of course, it would take longer to turn all that inventory and sell it. In the end, their cash conversion cycle was significant- it was more than 200 days from when they started spending cash to buy raw materials to when they got cash in the door. This was completely unnecessary and avoidable.
How to Improve Your Cash Conversion Cycle
Remember, the goal is to reduce the number of days between cash in and cash out. So, how do you reduce the cash conversion cycle? There are three main ways…
Shorten the cash conversion cycle times (duh!)
The most obvious way to improve your cash conversion cycle is to shorten one or more of the stages of the cycle. Take a look at your sales, fulfillment, delivery, and billing schedules and think creatively to figure out how to shorten the time each takes.
The company in our story needed to do this. Instead of doing things way in advance, they needed to find a balance between cost management and smaller batches. There were many upsides to this.
Firstly, their cash conversion cycle was shortened because they were no longer buying too far in advance. They began to buy just enough to match their monthly demand. Their production times were also reduced. Most importantly, they stopped spending money so far in advance of selling things, so their cash flow was better managed.
This company also made some changes to the timing of payments and collections. They talked to their vendors and changed their accounts payable terms so they could get better (ie. longer) terms at a slight premium. Instead of paying net 15, they could pay net 60, which meant that cash didn’t have to go out the door for 60 days. That’s cash that could be put towards things that help the business expand.
This effectively closed their conversion cycle to the point where they were almost getting cash in the door before it was going out. As you’d expect, this had huge implications for cash flow. They made two simple changes and it made all the difference in the world.
Reduce or (Better Yet) Eliminate Mistakes
Mistakes are the worst! We all make them from time to time, but they increase costs and make your cash conversion cycle worse. Mistakes create the need for rework.
The clearest example of how mistakes can affect your cash conversion cycle is for companies that create something for their clients, such as web design companies. Let’s say it takes you 90 days to create a website for a client.
Imagine you build everything out and deliver what you think will be the final product to the customer, and then the customer isn’t satisfied. Then, you need to spend another month fixing the problems and making it right before you can give the client the final bill.
This will impact your cash conversion cycle because you won’t get your final payment until the work is done to the customer’s liking. On top of that, it’s likely going to cost you because you have to pay staff to do the fixes.
The lesson here? Reduce the chance of making mistakes. In this case, that might mean a very clear onboarding process that ensures the client’s expectations are crystal clear. This will prevent misunderstandings later in the process.
Come Up With an Improved Business Model
A great example of an evolution of the cash conversion cycle by improving the business model is the IT consulting industry. Before I was a business strategy consultant, I ran an IT business. Back then, it was the norm to bill for time and materials at the end of the month for work done. That means it would sometimes take a month or more to get paid.
In the meantime, we had to pay our staff and all our costs in real-time. We had a long cash conversion cycle that made it hard to expand the business because we were using a lot of cash before it was coming in. For buying or selling computer hardware it was even worse. Often you would have to pay for the hardware and the customer would pay you after it was installed.
Enter the new and improved business model for the way that IT service companies worked. It evolved to a managed service provider model. Instead of working on a time and material basis, they would bill a flat rate for the month in advance. They could now collect money before they had to pay their staff for doing the work, which resulted in a zero-day or sometimes even negative cash conversion cycle.
Similarly, when it comes to buying hardware, customers now pay for the hardware in advance. Now there’s no cash demand on the business so they can use that cash to grow. This model made it far more profitable to run IT service companies than ever before.
Optimizing your cash conversion cycle is one of the key strategies for improving the financial health of your organization. After all, if you run out of cash, you’re out of business!
Need help thinking through how you can reduce your cash conversion cycle so that you have the cash you need to expand your business? Get in touch.