cash conversion cycleMany businesses operate amid a network of customers and suppliers. The focus of this article is on the use of the cash conversion cycle and funding business operations within one year, or what’s termed ‘current’ on a balance sheet.

Current assets include cash, accounts receivable and inventory while current liabilities include accounts payable, salaries payable and short-term debt payments.

We will discuss accounts receivable, accounts payable and the least liquid of the three, inventory. Focusing on these three items offers a better understanding of how to optimize efficiency so a business can remain as liquid as possible.

Lasting profitability comes not from the number of sales made, but how well the business coordinates all of these entities to ensure proper financing at all stages of operations.

Accounts Receivable

Accounts receivable are sales made on credit, not cash. Credit sales are a little trickier for businesses and waiting for payments is a major challenge when running a business. The owner (CFO, financial manager, etc.)  has to determine a set of payment terms for each customer, tailored to their ability to make payment. Obviously, the larger the potential customer, the more the business is willing to accommodate their repayment schedule.

Most invoices go out to customers on a ‘net 30’ basis, meaning payment is expected within 30 days. Depending on the customer and the industry, the payments may take 45, 60 or 90 days to come in.

For example, payments in the health care or medical space can take the full 90 days to be received (sometimes up to 150 days for some insurance companies and/or Medicaid/Medicare).1

As a general rule, accounts receivable that are past 90 days due are typically written off as unrecoverable and often sent to a debt collection agency. Some businesses turn to factoring companies to mitigate this cash flow gap.

Accounts Payable

The flipside of receivables is accounts payable, what the business owes to its suppliers or vendors. Accounts payable often come from the financing of inventory. Businesses will buy inventory on credit and then sell the inventory, again on credit. Ideally, the business wants to lengthen the time to repay suppliers for inventory (accounts payable) and shorten the time collecting cash from customers (accounts receivable). Salaries are also a type of accounts payable, known as salaries payable.

Inventory

Inventory is tangible assets a company possesses that will eventually be sold for cash. Inventory can be in the form of raw materials, a work-in-progress or a finished good. Retailers and manufacturers are very familiar with inventory and typically employ inventory management software to help account for it. But inventory that sits on a shelf gets less valuable by the day. Inventory can be thought of as cash not flowing through the business. Businesses desperately try and sell or turnover, their inventory as quickly as possible.

What is the Cash Conversion Cycle?

The cash conversion cycle, CCC, measures the delay between when a business must pay its suppliers and when it finally collects money from customers. It measures the amount of time (in days) that cash is tied up in working capital. The cycle is of vital importance to running a successful business because if they can’t manage their cash flows successfully, they face serious liquidity constraints and will soon be in default to business creditors. This can be especially troublesome for small businesses.

The cash conversion cycle incorporates all three of these accounting basics, accounts receivable, accounts payable and inventory. It is measured calculated as:

CCC= Days Sales Outstanding + Days of Inventory Outstanding – Days of Payables Outstanding

Ideally, a business would like to have the lowest number of days possible in its credit conversion cycle which would mean it doesn’t have to wait long for cash to come in from credit sales of its inventory (if the business is a service industry, disregard inventory).

How the Big Boys Do It

Large corporations control the cash conversion cycle to give them a competitive advantage. They can use their clout to delay paying suppliers until they can get paid by customers. Nowhere is the cash conversion cycle more important than in the retail industry. According to Bloomberg, Macy’s had a rather stagnant cash conversion cycle of 71 days last year, Walmart had an efficient 12 days and Costco’s was an enviable 4 days.2 This is due to Costco’s penchant for not having too many different items for sale, but the one’s they carry sell quickly. After all, it’s food we’re talking about. Macy’s has to deal with fashion cycles and fickle customer trends.

But Amazon is the best at managing its cycle. The retail giant enjoyed a negative cash conversion cycle in 2014 of 24 days. Amazingly, the -24 days is actually down from almost -40 in 2010.3 This means they wait until their customers pay before paying suppliers. They call it a ‘high inventory velocity’ (their suppliers probably call it something different). Amazon’s self-financing is partly why consumers enjoy inexpensive items.

You may be wondering what are the repercussions of such actions. For Amazon, not much. Since any supplier in the world would love to do business with Amazon, they tolerate the arrangement. But it is the American small business owner that is reeling in the face of such competition as they can’t enjoy similar economies of scale with regards to their financing.

What Can Small Business Owners Do?

It’s obviously difficult for small businesses to compete on an even playing field against such retail giants. But government agencies are starting to take notice of this supply-chain bully behavior used by some large, influential companies.

In 2014, President Obama announced a SupplierPay initiative where large companies committed to paying suppliers more quickly. While on the surface it may not help the situation much, the fact that such delayed payment tactics is being noticed by the government is a good sign for smaller businesses.

Helping small business is a theme to watch for as we enter the political season as employment is always a major talking point. Politicians know all too well that 64% of all new jobs are created by small business, according to the Small Business Administration, SBA.4 Further, small businesses and their owners are held in high regard by the public.

Consider an Online Masters in Accountancy Degree (MAcc)

If the concepts presented in this article interest you, consider a Masters in Accountancy (MAcc) degree. The curriculum of these programs include in-depth, balance sheet analyses, will financial professionals gain a broader understanding of the economics of running a business. With the above article, we see how a rather mundane topic (cash conversion cycles) is applied to a real world scenario. And the way these large companies approach their internal financing sources is anything but mundane.

Earn your MAcc Online

An online MAcc degree offers the best of both worlds. Besides the obvious benefits of flexibility, maybe the most important benefit to obtaining your MAcc online is career advancement. Entry-level competition can be fierce, but with an online Masters of Accountancy degree, you should be in a much more competitive position. The knowledge learned in these programs can help you land a challenging, high-paying position in finance, possibly with a CPA firm or any number of for-profit financial companies.

 

References:

Summary
Master Accounting Ratios with the Cash Conversion Cycle
Article Name
Master Accounting Ratios with the Cash Conversion Cycle
Description
What is the Cash Conversion Cycle? The cash conversion cycle, CCC, measures the delay between when a business must pay its suppliers and when it finally collects money from customers.
Author
Publisher Name
www.financialcareeroptions.com
Publisher Logo