Cash flow is one of the key performance indicators for most businesses, but it only shows a snapshot of an organization’s health. The cash conversion cycle indicates how long cash is tied up in inventory before a product is sold and converted into income.
A short cycle means you’re operating efficiently, minimizing unnecessary expenses, and producing a healthy income. A long cycle means resources are wasted housing unsold products, and sales numbers are likely weak or slow.
You’ll need to find ways to reduce your cash conversion cycle to improve your cash flow and liquidity.
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What is the cash conversion cycle?
The cash conversion cycle (CCC) – also known as the cash-to-cash cycle – determines the number of days it takes for a company to convert its inventory and other business resources into cash. Accounts payable teams also refer to this as the net operating cash cycle.
Companies that operate efficiently tend to have lower CCCs. But when businesses waste resources, and the accounts receivable departments delay securing payments, they tend to experience larger CCCs.
The cash conversion cycle is calculated by adding the Days inventory outstanding (DIO) to the Days sales outstanding (DSO) and then subtracting Days payable outstanding (DPO).
Cash Conversion Cycle Formula
CCC = DIO + DSO – DPO
It’s important to note that there isn’t a “one size fits all” cash conversion cycle. CCC can vary across industries, company sizes, and business models. A good rule of thumb is to compare your CCC against your company’s historical performance and competitors in your industry. If your CCC is longer than your competitors, it’s a sign you need to make changes.
What is a good cash conversion cycle?
A good cash conversion cycle is a short one. If your CCC is a low or a negative number, that means the business’ working capital is not tied up for extended periods, and your business has greater liquidity. When your business has greater liquidity, it has greater agility to invest in other opportunities when they present themselves.
If your CCC is a positive number, you do not want it to be too high. A positive CCC reflects how many days your business’s working capital is tied up while waiting for your accounts receivable to be paid. You may have a high CCC if you sell products on credit and have customers who typically take 30, 60, or even 90 days to pay you.
For example, a cash conversion score of .25 is generally considered “good” and shows a company that turns a dollar invested into 25 cents of recurring revenue. That is a healthy company that has a scalable model.
Key takeaway? The shorter the CCC, the better. But if you have a high or positive cash conversion score, some improvements are needed to reduce it.
Five ways to improve your cash conversion cycle
There are several ways you can shorten your business’s cash conversion cycle. For one, ensure your accounts receivable process is as efficient as possible. Regardless of your situation, consider the factors below to reduce your cash conversion cycle effectively.
1. Optimize your inventory
The longer it takes for a business to sell its inventory, the longer the CCC is. Businesses must move inventory efficiently, building or purchasing only what they need and using all the tools available to keep the cash conversion cycle manageable. This starts with purchasing only the needed inventory and optimizing the inventory conversion cycle.
Whether a company deals with raw materials or finished products, it should aim to have only what it needs readily available. Adopting a fixed reorder system is advisable. This can be done by leveraging data derived from your accounts receivable solution. You should be able to mine that data for sales trends, time spent in inventory, and other key performance indicators that can help determine the ideal amount of inventory to have on hand.
This is – of course – not possible if you have no inventory. The same basic idea still applies to service-based or software companies. Inventory optimization is based on consistently moving products, creating a steady flow of income without facing a self-inflicted financial burden. Businesses without inventory should look at Lifetime Customer Value – the average customer’s cash flow over the lifetime of their business relationship, minus the costs of acquiring them as a customer.
2. Encourage quicker payment
How quickly the customer pays directly impacts your CCC. So, encouraging earlier payment is an effective strategy for reducing your cash conversion cycle. Depending on your business, requesting upfront payments – or at least a deposit – may be a viable option. Immediate payments are an easy way to increase cash flow and shorten the cash conversion cycle.
Most companies punish their customers for late payments, but it’s rare to provide incentives for paying early. Most people respond better to positive enforcement. Here are some tips to encourage your customers to pay sooner so you can collect accounts receivable quickly:
- Offer temporary discounts for early payments.
- Provide better credit terms for customers who consistently pay upfront and on time. Better yet, keep credit terms at 30 days or fewer for customers to ensure quicker payment.
- Promise faster delivery times for customers who also consistently pay upfront and on time – speeding up delivery times can help motivate customers to pay faster.
- Simplify your invoices to include only the necessary information so it’s easier for customers to follow and understand.
3. Extend days payable outstanding
It’s beneficial for customers to pay a business immediately, but it’s not necessarily beneficial for companies to pay their vendors immediately. Of course, on-time payments are crucial but you should avoid sending invoices early. It’s a matter of extending your DPO (ratio of the average number of days it takes for a business to pay its vendors over a certain amount of time) so you can shorten your CCC.
In fact, 53% of companies studied in the J.P. Morgan Working Captial Index 2020, and 67% of them shortened their CCC because they improved their DPO.
4. Adjust accounts payable periods
Another effective strategy is optimizing the length of accounts payable outstanding. This provides additional time to receive payments, increasing flexibility and shortening the cash conversion cycle. By delaying your payables – even a few days – you’re maximizing the value of each dollar of your cash flow. The easiest way to do this is by lengthening the time accounts payable are outstanding – and the easiest way to do this is through an automated A/R solution. This applies to any business model. Setting up bill payments on a longer cadence – say 45 instead of 30 days – gives your cash conversion more room to breathe.
5. Implement automated software
Leveraging the superior return on investment of an automated A/R solution is the most efficient way of improving cash flow. Larger changes like supply chain improvements or banking processes can take significant time and cause disruptions. Implementing an A/R solution is easy and has a lasting impact.
If you’re struggling with your cash conversion metrics, getting money in your hands quickly will help. Using automated A/R tools to send timely invoices, automatically sending follow-ups, and making it easy for customers to pay will decrease days payable outstanding.
With accounts receivable automation, you’re using fewer resources and increasing cash flow, which means businesses can be more flexible in their decision-making.
Shortening the Cash Conversion Cycle with Invoiced’s Automated A/R
The cash conversion cycle reflects how well a company converts invested dollars into value. Reducing your cash flow conversion time is key to improving liquidity. It means your business has the cash flow to do what it wants, be it increasing staffing, developing a new product, or delving into new markets. It’s a powerful, telling metric that can have a significant impact.
Automated A/R tools are the best way to reduce the cycle. Implementing a solution to remove the complexity of A/R operations can positively increase the bottom line without significantly changing how you do business. Invoiced accounts receivable automation software and accounts payable automation software simplify the cash flow process, saving your business time and money – all while improving accuracy and reporting.
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