Rising inflation and unpredictable supply chains are putting the squeeze on companies’ cash flows. The following article will cover how to calculate your cash conversion cycle, the benefits of lowering it, and how your company can do so.
What is the Cash Conversion Cycle?
The Cash Conversion Cycle (CCC) is the length of time, in days, that it takes for a company to convert cash outflows into cash returned to the company. This metric takes into account the amount of time a company needs to sell its inventory, collect its receivables, and pay its bills without incurring penalties. Practically speaking, CCC can be calculated by adding and subtracting the following ratios (calculated in days):
Accounts Receivable Turnover + Inventory Turnover – Accounts Payable Turnover = CCC
External Events Impacting the Cash Conversion Cycle
The supply chain disruption resulting from the pandemic lengthened companies’ CCCs as they struggled to source raw materials and get products to market. Many companies also saw their CCCs stretch to keep up with inflation, a side-effect of adjusting prices to offset increasing costs.
Now, just as companies have begun adjusting to this new world, supply chains are returning to their pre-pandemic reality, causing an increase in inventory levels. With interest rate hikes becoming the norm, holding this inventory is more expensive than it’s been in a decade, leading to a liquidity crunch for many companies. This lack of available cash decreases companies’ capacity to fund the expansion of business into new product lines and markets.
Lowering Your Cash Conversion Cycle
Before the pandemic flipped the table, efficient supply chain management was a strong strategy for reducing a company’s CCC. Now, with uncertainty roiling the supply chain, some companies have renewed their focus on Accounts Receivable collections and Accounts Payable cycles to offset the increase to the inventory cycle.
The simplified example below shows how Company X is handling the liquidity crunch and shortening their CCC. The inventory cycle for Company X increased 25 days during the pandemic. In this example, Company X was able to focus on payment collection, reduce A/R balances, and stretch out payables a few days to offset the reduction in inventory turnover.
|Cash Conversion Cycle|
|(Avg. Inv. / COGS) x 365||125||100|
|(Avg. AR/Net Sales) x 365||30||50|
|(Avg AP/COGS) x 365||-35||-30|
|Cash Conversion Cycle (Days)||_________________________|
Other Tips for Lowering Your Cash Conversion Cycle
Outside of persistence and offering discounts, other tactics that may lower your CCC include:
- Speeding up your invoicing process
- Digitizing customer payments and signing customers up for automatic payments, when possible
- Sending additional follow-up and payment reminders and revaluate payments terms
- Managing payables by not early paying suppliers
- Asking customers for additional advance deposits
- Reducing shipping times
While the inventory cycle usually provides the largest impact to the CCC, it will take some time for companies to reduce this cycle. However, even improving the CCC a day or two can have a significant impact on cash flow. Follow the tips above for lowering your CCC and send me an email if you have any questions.
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