The Importance of Understanding Cash Conversion Cycle

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Generally speaking, there are 3 sources of cash for a growing company.  The most commonly discussed are equity and debt funding.  Both come at a price.  Debt comes with interest.  Equity always comes with some sort of dilution of your own equity value in the company.  The third source of cash is a more efficient use of the cash already in your business.  Understanding where that cash is locked away and how to better access it will be how you’ll get at this, your cheapest source of growth capital.

 

There are many ways to understand the efficiency of cash flow management in your business.  One way is to measure how quickly a company can convert cash on hand into even more cash on hand.  The Cash Conversion Cycle metric is an attempt to get at this answer by measuring how cash moves through the typical ‘pools’ of cash in a company.  Those pools typically fall into one of three categories.  Cash invested in Inventory, Customers and from Vendors.  More specifically, the calculation measures how fast a company can convert cash on hand into inventory and accounts payable, through sales and accounts receivable, and then back into cash.  The lower the CCC, the more efficient a company is at turning cash into more cash.

 

Measuring CCC

 

Cash Conversion Cycle is measured with a simple formula:

DIO + DSO – DPO = CCC

 

Here is an example of a business with the following data:

Days Inventory Outstanding: 180

Days Sales Outstanding: 60

Days Payables Outstanding: 30

CCC: 180 + 60 – 30 = 210 days

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Let’s touch on each element:

 

DIO: Days Inventory Outstanding

(Formula = Inventory / Avg Daily COGS)

Speaking generally, this metric measures how long it would take to sell through all of your inventory.  It asks, “How long is cash tied up in inventory?”  It is measured by taking the full value of inventory from the balance sheet and dividing it by your average daily cost of goods sold.  It is recommended that you take at least 60-90 days of Cost of Goods Sold to determine a good average.  Use even more if you have a seasonal business.

 

DSO: Days Sales Outstanding

(Formula = Accounts Receivable / Avg Daily Sales)

DSO measures how long it takes, on average, to collect from your customers once a sale is made.  Of course, if you have only cash or credit card sales, your DSO will be zero.  Smaller, or even negative (if you collect ahead of a sale) is good.  Measure this by taking the full account receivable value from your balance sheet and dividing it by your average daily sales.  Once again, use at least 60-90 days of history for your daily sales.

 

DPO: Days Payable Outstanding

(Formula = Accounts Payable / Avg Daily Expenses)

DPO measures simply how long your vendors allow you to wait to pay them.  Your denominator here is average daily expense and there are many ways to measure it.  Some will argue whether payroll or cost of goods should be included.  We recommend that you include in your average daily expenses all those expenses that you might be able to influence how long you take to pay them.  With that perspective, most companies will include all expenses, except payroll.  This is because all of your expenses, with the exception of payroll as a last resort, can likely be sped up or down as needed to assist with managing cash.

 

Once each metric is measured, they can be combined into the CCC which then indicates the company’s ability to employ short-term assets and liabilities to generate cash.  It measures the liquidity risk you take when you put cash into growth strategies.  It demonstrates how long it will take until you see a return.

 

Analyzing CCC

 

Investors often use this metric to compare close competitors, as a low CCC signifies an opportunity to improve cash generation.  But for those wanting to use this metric internally, there are two things to learn from an analysis of your CCC.

 

First, as mentioned, improving the efficiency of capital already in your business is your cheapest source of additional capital to grow your business.  It doesn’t cost you any interest or equity dilution.  A study of the overall CCC and its individual components will help you understand where you can streamline.  For instance, you may dig deeper into your Days Inventory Outstanding and determine to move away from some slower moving products.  Whether or not those products are profitable, you may decide you want access to that cash to grow the business more efficiently elsewhere.

 

Two, if you measure the CCC over time (and you can measure backward by simply looking at historical data) by graphing CCC and its component parts on a trend-line, you can learn whether you’re improving or not in recent months.  This is particularly helpful to catch problems early as they arise in your business.  These patterns over time are very telling.

 

Paying close attention to cash management by measuring how efficient you are as an organization is just the first step to unlocking your cheapest source of capital.  Once you’ve gained understanding you can begin to lay out a plan for improvement.  Below are two additional sources of good information on measuring and analyzing your cash conversion metric.

 

Read more:

Cash Conversion Cycle – CCC (AMZN)

Investopedia – Cash Conversion Cycle

 

 

David Chase, Managing Partner at Advanced CFO Solutions, has experience in small to medium private companies and large public companies as a senior operational and financial leader.  With 15 years in finance, a CFO of multiple entities and divisional EVP experience, Dave has a breadth of experience.  Dave has led or been instrumental in raising multiple rounds of equity and debt in excess of $450 million.

http://www.advancedcfo.com

from http://advancedcfo.com/cash-conversion-cycle/

What is Operating Cash Flow?

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What is Operating Cash Flow?

 

You may have heard of cash flow, but what exactly is operating cash flow? While cash flow is the net amount of cash moving in and out of a business, operating cash flow is something different. Operating Cash Flow (OCF) is a measure of the amount of cash generated by a company’s normal business operations. Since it adjusts for liabilities, receivables, and depreciation it is a more accurate measure of how much cash a company has generated than other measures of profitability such as net income.

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Why is operating cash flow important?

 

No matter how you choose to measure cash flow, it is still important. Cash flow (and OCF) is what helps companies expand, launch new products, pay dividends, and even reduce debt.

 

Without positive cash flow, a company doesn’t have as much flexibility. They may have to borrow money, or in the worst case – go out of business. Having a negative cash flow is acceptable at times, but should not become a habit. If the negative cash flow can be attributed to temporary expansion costs, then that is fine. If the negative cash flow is because of a poor investment or other mistake than won’t correct itself, then your business may be in trouble.

 

How do you calculate operating cash flow?

 

Generally, a statement of cash flows breaks out into three different categories per period: cash flows from operations, cash flows from investing activities, and cash flows from financing activities. OCF is calculated using the following formula:

 

Operating Cash Flows = Net Income + Noncash Expenses (Usually Depreciation Expense) +/- Changes in Working Capital

 

How does operating cash flow relate to the big picture?

 

In the end, OCF reveals how much cash is generated from the core operations of your business. This is very important to the overall health of your business and the larger picture of cash flow. OCF is just one part of cash flow, and it is typically a big part of what makes your company profitable.

 

There is a lot more to cash flow and operating cash flow, but the essentials remain. To be a profitable business, you must have a positive cash flow. If you are not positive, then don’t delay in looking for ways to solve this problem. This begins by looking at your OCF, analyzing a cash flow statement, and making plans for the future. Wherever your company is financially, it is important to look towards the future, free up cash to invest in growth, and be ready for any hard times that may come your way.

 

 

 


David Chase, Managing Partner at Advanced CFO Solutions, has experience in small to medium private companies and large public companies as a senior operational and financial leader.  With 15 years in finance, a CFO of multiple entities and divisional EVP experience, Dave has a breadth of experience.  Dave has led or been instrumental in raising multiple rounds of equity and debt in excess of $450 million.

http://www.advancedcfo.com

from http://advancedcfo.com/what-is-operating-cash-flow/

Cash Flow Analysis

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We have heard it said many times, “cash is king”. Because its true! You need cash to start, operate, and expand your business, but many small business owners often have trouble managing and maintaining cash. Inaccurate cash flow analysis can affect the everyday operations of your business and your eligibility for loans and investments.

 

Cash flow is simply the movement of money in and out of your business:

  • Inflow which comes from operations such as the sale of goods and services, loans, lines of credit, and asset sales.
  • Outflow which occurs during operations such as business expenditures, loan payments, and larger capital purchases.

 

It’s crucial to balance cash in and out while maintaining a reasonable balance of cash at all times. An effective cash flow system will help you manage funds to cover operational costs and bills and help you foresee potential problems in the future. Every business should have a short term, 13 week cash flow projection that projects cash in and out by week, but also longer term annual cash flow projection.

 

Financial statements have 3 basic statements, 1) Profit and loss statements (income statements), 2) Balance Sheet and 3) Statement of Cash Flows. All 3 of these statements are based upon historical information, but all of them can be used to determine projections for future cash flow trends of your business. However, a cash flow statement serves an important and independent purpose – it accounts for non-cash items and expenses to adjust profit figures. Cash flow analysis statements display not only changes over time, but also available net cash.

 

Cash flow statements are generally separated into three parts:

  • Operating activities: This section evaluates net income and loses of a business. By assessing sales and business expenditures, all income from non-cash items is adjusted to incorporate inflows and outflows of cash transactions to determine a net figure.       It incorporate changes in current assets and current liabilities, which impact operating cash of the business, such as change in receivables and payables.
  • Investment activities: This section reports inflows and outflows from purchases and sales of long-term business investments such as property, equipment, and securities. For example – if your bakery business purchases an additional piece of kitchen equipment, this would be considered an investment and accounted for as an outflow of cash. If your business then sold equipment that was no longer needed, this would be considered an inflow of cash.
  • Financing activities: This section accounts for the cash flow trends of all money that is related to financing your business. For example: if you received a loan for your small business, the loan itself would be considered an inflow of cash. Loan payments would be considered an outflow of cash, and both would be recorded in this part of the cash flow analysis statement.

 

Making cash flow projections and computing cash flow statements can be confusing if you have never managed these types of finances before, but they are critical to managing the growth of your business. Make sure you are performing an analysis of historical and projected cash flows in order to keep your business thriving, because cash is king.

 

 


JB Henriksen is a partner at Advanced CFO. At Advanced CFO, we provide outsourced accounting and financial services. We have served with more than 450 companies. Our clients see us as their strategic, outsourced CFO. We provide CEOs with critical information so they can make key decisions with confidence. We do this by leveraging our experience and technology to provide actionable information and results. And, we do it for a fraction of the cost of a full time employee. For more information, click here.

www.advancedcfo.com

from http://advancedcfo.com/cash-flow-analysis/