On the surface, cash flow is one of the key performance indicators businesses should be most concerned about. However, cash flow only shows part of the picture. The cash conversion cycle is a powerful metric for determining overall business health, showing how quickly a company can convert goods and services into cash.
It is calculated by:
(Days Sales in Inventory) + (Days Sales in Receivables) - (Days Payables Outstanding)
The cash conversion cycle is a good indicator of 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 are producing a healthy amount of income. A long cycle means resources are being wasted housing unsold product and sales numbers are likely weak.
Companies that don’t hold inventory, like software or SaaS providers, shouldn’t be as concerned with cash conversion cycle. Instead, they should look at a relatively new metric: cash conversion score.
Simply, it measures how capital spent has been converted into accounting rate of return (ARR), or the ROI of each dollar invested into a company.
Cash conversion score is measured by:
ARR / (Equity + Debt - Cash)
It reflects how a company is converting invested dollars into value. A CCS of .25 is “good” and shows a company that turns a dollar invested into a 25 cents of recurring revenue. That is a healthy company.
A mature company may have a cash conversion score of 1.0, which is excellent and indicative of a strong business.
Here, we’ll show you how to maximize your cash conversion metrics and operate your business much more efficiently.
Improve Cash Flow Management
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.
By automating this, you’re using fewer resources and increasing cash flow, which means businesses are able to be much more flexible in their decision making.
Adjust Accounts Payable Periods
Of course, any business is spending as well as receiving payments. By optimizing the length of accounts payable outstanding, you’re giving yourself 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. This applies to any business model.
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. By setting up bill payments on a longer cadence - say 45 instead of 30 days - you’re giving your cash conversion more room to breathe.
Work with Your Customers
It would be nice if all customers were the same and paid on the same schedule, but that is of course not true. Understanding customers and applying empathy will get your paid quicker and, maybe, help retain a potential long-term customer.
Timing a customer’s billing cadence to complement their pay cycle reduces the days receivables are outstanding and decreases the potential of late payments. A robust customer payment portal helps here, allowing customers to set up their own payment schedules on their own time.
Modify Your Accounts Receivable
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.
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 changing banking processes can take significant amounts of time and cause disruptions. Implementing an A/R solution is easy and has a lasting impact.
Optimize Your Inventory
If you maintain an inventory, the worst thing your product can do is nothing. Sitting in storage is worse than not being made at all. Resources have already been used to make a product. Then more resources are used to house them while they sit in a warehouse losing value.
Businesses must move inventory efficiently, building or purchasing only what they need and using all the tools available to keep the cash conversion cycle at a manageable level. This starts with purchasing only the inventory that you need and optimizing the inventory conversion cycle.
Be they raw materials or finished products, businesses should aim to have only what they absolutely need 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 the idea of consistently moving product, 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.
Shortening Cash Conversion with Automated A/R
Shortening the cash conversion cycle means your business has the cash flow to do what it wants, be it increase staffing, develop a new product, or enter new markets. It’s a powerful metric that can have a significant impact.
Automated A/R tools are the best way of reducing the cycle. Implementing a solution designed to remove the complexity of A/R operations can positively increase the bottom line, without significantly changing how you do business.