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How to Improve the Cash Conversion Cycle to Preserve Cash Flow

By 07.14.21July 20th, 2021No Comments

Managing cash flow to meet financial obligations is one of the most challenging aspects of running a business. In an ideal world, wholesalers and distributers push product and inventory quickly through the operating cycle. The goal is to reduce the time between purchasing stock and converting it into sales to preserve cash flow. The speed and efficiency of this cycle has a profound effect on a more important working capital metric known as the cash conversion cycle (also known simply as the cash cycle). A variety of conditions influence how quickly a business is able to turn the initial investment of purchasing inventory into a profitable return. The state of the economy, the health of the industry and how well the business is managed, all have an effect on this cycle. In this article we discuss various ways for managing cash flow, allowing wholesalers and distributors to stay ahead of the cash conversion cycle and grow.

What is the Cash Conversion Cycle?

The cash conversion cycle measures how many days it takes for a business to convert cash into inventory and then back into cash through the sales process. A good cash conversion cycle is a short one. A protracted cycle, in which cash is tied up over an extended period of time, hinders a company’s ability to be financially flexible and able to invest further. By working to reduce the cash conversion cycle to a minimum, wholesalers and distributors have better control to increase efficiency and profit margins, and are better positioned to grow.

It is a simple calculation to determine the length of your cash conversion cycle:

Days Inventory Outstanding – Days Payable Outstanding + Days Sales Outstanding = Cash conversion cycle

Days Inventory Outstanding (DIO): The number of days on average that your company takes to purchase inventory and convert it into sales.

Days Payable Outstanding (DPO): The average number of days it takes your company to pay its accounts payable to services, vendors and suppliers.

Days Sales Outstanding (DSO): The number of days it takes your company to collect payment from accounts receivable.

Cash conversion cycle example:

ABC Inc. is a wholesaler of mechanical parts. On average, ABC Inc. purchases enough inventory to carry 60 days turn over, or the number of days to sell the inventory stock (DIO). ABC Inc. has a policy of paying their accounts receivable in 30 days to their suppliers (DPO). They have steady customers who on average pay their invoices in 42 days (DSO). The formula for ABC’s cash conversion cycle is as follows:

60 (DIO) – 30 (DPO) + 42 (DSO) = 72 Days

In this example ABC Inc. has a 72 day cash conversion cycle, meaning that they need 72 days of working capital to purchase inventory and convert it back into cash.

How to Improve Your Cash Conversion Cycle

The shorter your cash conversion cycle, the better. To shorten this cycle, you need to adjust the three variables of the formula:

  1. Days Inventory Outstanding: Carrying inventory stock requires an initial cash outlay to purchase the stock and an additional cost to store it. Work to improve sales processes and shorten the time it takes to turn inventory into sales. Reduce inventory shelf life by developing good working relations with suppliers to manage enhanced Just-In-Time inventory practices. For companies that deal with smaller volumes to individual customers, drop shipping allows your business to order stock and have the supplier deliver directly to your customer. The shorter the time your company has between the purchasing of stock and converting it into a sale, the better!
  2. Days Payable Outstanding: The longer the period of time to pay for inventory, the better for your cash conversion cycle, but it may weaken your relationship with suppliers and negatively impact your company’s credit score. Manage this activity carefully to balance the benefits to your cash flow against the stress it places on your supplier relationships and any damage it may cause to your company’s credit score.
  3. Days Sales Outstanding: Shortening the time it takes to collect payment on outstanding accounts receivable invoices is critical to improving your company’s cash conversion cycle. A good strategy is to offer early payment discounts, encouraging your customers to pay their invoices early and benefit from a reduction in cost. Another strategy is to shorten your accounts receivable terms – instead of providing a 30 day term, shorten it to 15 days. This will speed up the average time to collect payments, but can negatively impact relations with your customers. Yet another effective strategy to improve the collection process is to encourage your customers to pay their invoices on time. This requires a trained staff and greater leadership time to improve the time to collect accounts receivables without harassing your customers and damaging relationships.

Of the three variables listed above, working to shorten DSO has the greatest positive impact on improving your company’s cash conversion cycle. To this end, partnering with a reputable invoice factoring company that knows the wholesale and distribution industry and familiar with your needs is an effective strategy.

What is Invoice Factoring?

Invoice factoring (a form of invoice financing) is the practice of selling accounts receivable invoices at a discount in exchange for immediate cash. It is a simple process:

  • Your company delivers product, invoices your customer and submits a copy of accounts receivable invoices to the factoring company for immediate payment.
  • Advance payments of up to 90% of the invoice face value is transferred directly into your account within 24 hours. The balance (called the “Reserve”) for each accounts receivable is paid as soon as your customer remits full payment for the invoice.

This process is the fastest and most hassle free financing option for accelerating cash. The end result is a vastly improved cash conversion cycle.

Using the example above, if ABC Inc. used invoice factoring they would see an improved cash conversion cycle – reducing the number of days from 72 to 31 days:

60 (DIO) – 30 (DPO) + 24 hours (DSO) = 31 Days

This represents a reduction of 41 days in ABC Inc.’s cash conversion cycle. This is a significant improvement in ABC Inc.’s ability for accelerating cash and will strengthen their facility to reinvest and grow the business. For even better business cash flow, it is possible to achieve negative cash conversion cycle by collecting payment for products delivered to your customers prior to paying suppliers for that product. This is made possible by combining invoice factoring with drop shipment. In this circumstance, your customer receives the product directly from the supplier and is invoiced immediately. The accounts receivable invoice is submitted to the factoring company for an advance of up to 90% paid into your account within 24 hours. This money can now be used as a cash reserve until you pay your supplier. Alternatively, you can pay your supplier early to take advantage of an early payment discount. Either way, Company ABC has significantly improved its business cash flow situation and is building a better credit history for future financing needs.

To expedite payment of the reserve and improve your company’s account receivable management, reputable factoring companies provide a professional collections team. This team is trained to retain good customer relations as they work to reduce your company’s DSO and help mitigate potential loss from bad debt.

The greatest advantage of using invoice factoring is its ability to provide escalating access to working capital as your company grows. The more accounts receivable invoices your company issues to credit worthy customers, the more capital is immediately transferred to your account. This important feature allows the financial flexibility to take on new customers and expand operations without depleting available funds.

Qualifying for Invoice Factoring is a Simple Process

Compared to bank financing which takes weeks and months of due diligence to process, qualifying for invoice factoring is fast and simple. If your company issues accounts receivable invoices to a base of credit worthy customers, you are well on your way to first funding.

Once approved, your company can start submitting accounts receivable invoices to receive immediate payment. Managing cash flow with invoice factoring allows your company to easily make payroll, pay suppliers, buy equipment, expand into new markets or take advantage of business growth opportunities. Unlike a bank loan, there are no restrictive covenants to limit your ability to reinvest and grow. Invoice factoring is the ideal financial solution for accelerating cash flow and providing the flexibility to take businesses to the next level.

For more information about managing cash flow and how a reputable factoring company can help you run a better business, visit eCapital.com.