Working capital efficiency is crucial to your business success but it is being seriously impacted by the macro-environment.

We are currently facing a period of economic change unlike we have experienced for many years – rising interest rates, rising cost-push inflation, increased capital costs, rising operating costs, supply chain and labour constraints, increasing costs of living, a looming recession and a lingering COVID-19 pandemic.

The uncertainty caused by these events has highlighted the critical importance of cash flow management. In response to how costly debt has become and the forecast for future increases, organisations are reassessing their capital expenditures. CFOs, finance leaders and credit teams want to understand how budget profiles have changed or are likely to change, and which investments should be postponed or cancelled.

Businesses have emerged from the COVID-19 pandemic leaner, meaner, and smarter. Out of necessity, they have embraced disrupted change to their core business model, reduced operating costs, embraced hybrid work practices, raised prices, and restructured their real estate leases and debt obligations, among other cost reduction initiatives

These strategies have allowed them to conserve precious cash for future use. But many still have ‘untapped liquidity’, but where should you look for this alternative cash resource?

What’s the secret to tapping into your business’s potential liquidity?

Many businesses do not focus strongly enough on working capital initiatives. This is historically due to the low value of their weighted-average cost of capital and a having a greater focus on driving sales revenue and profitability. With increasing interest rates and debt becoming more expensive, more and more businesses will have to prioritise their working capital strategies and determine which internal efficiencies can be streamlined to use as a source of cash.

The simple answer to this can be found in a less well understood but certainly under-appreciated financial metric — the cash conversion cycle (CCC).

For organisations that need to manage physical inventory, such as those involved in manufacturing distribution, construction, or retail, inventory control and management are critical components of the CCC. One of the main objectives of working capital is to run a business with minimal cash being tied up in inventory or accounts receivable. The CCC follows this process from purchasing inventory to settling accounts receivable and accounts payable. This doesn’t apply to businesses that deal with intangible goods, as they don’t need to manage physical inventory.

The intrinsic value of the cash conversion cycle

The CCC is just one of several quantitative measures that help evaluate the efficiency of a company’s operations and management. It is an important working capital metric and leading indicator of operational efficiency, liquidity risk, and overall financial health. Simply put, it measures how efficiently your organisation is managing its working capital and how many days it takes for the business to convert cash into inventory, and then back into cash, via the sales process.

The liquidity of any organisation can be ’trapped’ in each of the three key components of working capital, including processes – accounts receivable, accounts payable and inventory. Effectively, the cash cannot be used for other purposes as it is moving through the entire supply chain process. The shorter the value of an organisation’s, the less time that cash is trapped in its operations within accounts receivable and inventory.

But how can you avoid this situation? Well, to accelerate cash flow, you need to improve performance in one of the following three financial metrics i.e. decrease DSO, decrease DIO, and increase DPO. All items contribute to lowering the value of the CCC.

How to calculate the cash conversion cycle

Cash Conversion Cycle

Formula: Cash Conversion Cycle (CCC) = Days inventory outstanding (DIO) + days sales outstanding (DSO) – days payable outstanding (DPO).

Criteria and explanation

Days inventory outstanding (DIO) and days sales outstanding (DSO) are associated with business cash inflows, while days payable outstanding (DPO) represents cash outflow. This is why days payable outstanding (DPO) is the only negative figure in the formula calculation.

So, here is another way to view the formula calculation. Days inventory outstanding (DIO) and days sales outstanding (DSO) are both linked to inventory and accounts receivable, which are both considered short-term assets and thus taken as positive indicators. Days payable outstanding (DPO) is linked to accounts payable, which is considered a liability, and thus taken as a negative indicator.

DIO (Days Inventory Outstanding)

Formula: DIO = (average inventory balance for period/cost of goods sold [COGS]) x Number of Days in the Accounting Period.

Key components

• DIO shows how quickly inventory is sold.
• Selling stock faster has a positive impact on working capital, as it means that less cash is ’trapped’ in unsold goods or inventory.
• Reducing DIO indicates the more efficiently the business is converting working capital into Inventory, and then back again.
• A smaller DIO figure is the best result here.

DSO (Days Sales Outstanding)

Formula: DSO = (Average accounts receivable amount for period/total credit sales in the same period) x number of days in the accounting period.

Key components

• DSO shows how long it takes to collect cash from customers.
• Faster sales collections have a positive working capital impact.
• Reducing DSO will accelerate cash flow into the business.
• A smaller DSO figure is the best result here.

DPO (Days Payables Outstanding)

Formula: DPO = ( Accounts Payable / Cost of Goods Sold [COGS]) x Number of Days in the Accounting Period

Key components

• DPO shows how long it takes to pay suppliers.
• Longer payment durations have a positive impact on working capital.
• Increasing DPO indicates the business ability to hold onto cash for longer periods, after the sale of inventory.
• A larger DPO figure is the best result here.

Understanding the Cash Conversion Cycle results

There are many financial ratios that organisations use to calculate and enable a real-time view of their business performance. The CCC is not one of them.

The purpose of the CCC is to provide a holistic view of business performance by tracking results over an extended time and using this information to benchmark against your market competition.

The CCC is a useful management tool but best utilised by select industry sectors, such as manufacturing, distribution, construction or retail businesses that are dependent on inventory management and related operations. The CCC is not particularly relevant to service and consulting businesses, which will find financial ratios such as the Debt-to-Equity Ratio or the Return on Equity Ratio more suited to their analysis requirements.

A working example of the Cash Conversion Cycle

Calculating your Cash Conversion Cycle may seem intimidating at first, but it’s a simple process that requires a basic understanding of the metric elements involved with the CCC calculation.

The information from the above-mentioned figures are standard items and referenced on the balance sheet and income statement (or profit & loss statement).

Once accurate values are determined from the DIO, DSO, and DPO calculations, simply convert them into the CCC formula. Below is a hypothetical example on how to calculate the CCC and compare results vs ‘Competitor A’. This simple CCC comparison is to determine whose cycle is better (same industry sector) and who is currently more efficient in its operational areas.

Analysis of results

Well, the overall analysis and variance in results makes for interesting viewing! Therefore, it takes Competitor A approximately 34.9 days to turn its initial cash investment with inventory back into cash and when compared to your CCC result of approximately 53.2 days.

With the CCC variance of (-18.3 days), if the normal course of business continues and all other elements remain constant, Competitor A will still be better at managing its working capital and more efficient in delivering its business objectives.

Next Steps?

Determine your elements of change, identify cash opportunities, then prepare your action plan to unlock “free” cash from operational areas, and secure internal funding to help grow your business.

Positive (short or long) vs negative results

• A positive CCC represents the number of days for a business to turn cash into inventory, and back again.
• The shorter the CCC, the better an organisation’s internal management. It is better at selling its inventories and recovering cash from its customer sales, while also paying its vendors.
• The longer the CCC, the more likely that an organisation has specific internal management issues and inefficiencies in using its short-term assets. It may also indicate a long period to collect payment arrears from its customers or may be ineffective at forecasting demand for its products (time to convert Inventory into sales) or may have inconsistent supplier terms for releasing payments to its vendors.
• A negative CCC represents the number of days it takes for a business to receive payment for the inventory it sells, but before paying its suppliers. Alternatively, your vendors are financing your business operations.

Analysis and results comparison – internal vs external (benchmarking)

• The analysis and results derived from the CCC should always be compared to other organisations but operating within the same industry sector and conducted on a trend analysis (quarter, year-on-year).
• The typical length of the CCC will vary considerably between different industry sectors based on the nature of business operations, meaning there is no single figure that represents a good or bad CCC.
• In addition, comparing the cycle (and previous periods) of your business to its market competitors helps determine whether your business’s CCC is ‘normal’ compared to industry competitors and gauge whether its working capital management is deteriorating or improving.

Additional funding or investments

• Investors, lenders, and other financing sources often assess a business’s CCC and other financial metrics to determine both its financial health and its liquidity, before deciding whether to approve additional loans or consider long-term investments.
• The more liquid an organisation is, the more easily it can pay back loans, meet its other financial obligations and invest in business growth.

Summary

In a competitive business environment, CFOs and finance leaders are responsible for optimising Working Capital Management in their organisation. By actively monitoring changes in your CCC, comparing to past business performance, and benchmarking to industry competitors, this allows for the analysis and identification of trends and helps anticipate strategic pivots along your future path.

Optimising your CCC is a powerful metric, but good information is only useful if you do something with it! There are practical, operational, and commercial limitations on how low working capital levels can fall without adversely affecting operational performance and both customer and vendor relationships. But it enables you and your business to be nimble, analyse where cash improvement opportunities exist, and then undertake the change transformations required towards a more profitable and sustainable future.