The purpose of the Cash Conversion Cycle (CCC) is to calculate the turnover rate of resources into cash flow. Depending on the industry, the receivables might have a longer or shorter cycle to when they are collected. This will affect your cash flow in reducing your payables.
To put it simply, the Cash Conversion Cycle consists of your sales, inventory, and payables.
To calculate the Cash Conversion Cycle, use the following formula:
(DSO + DIO – DPO = CCC)
DSO is your Daily Sales Outstanding. DIO is your Daily Inventory Outstanding. DPO is your Daily Payables Outstanding.
To increase cash flow, you must reduce your cash conversion cycle by doing the following:
Your company can improve its cash conversion cycle through any of the following ways:
By improving the DSO, there is more flexibility in cash flow. There are many ways to improve DSO (see below). As a financial leader, you are responsible to improving the turnover of receivables by establishing an effective process.
Start by examining your credit policy. Then check the credit ratings for new large orders. Those accounts that are high-risk or slow to pay should get up-front payment or a retainer.
Next, segment your customers to determine who’s profitable and who’s slow to pay.
Also, have a dedicated collections person.
Invoice immediately using clear, easy-to-read invoices.
Identify disputes and resolve them quickly. Furthermore, discuss dilution and its effect on financing.
Incentivize collectors based upon collection goals.
Also, incentivize sales force to improve cash flow.
Pay commissions off cash receipts or back out bad debts from commissions.
To improve DIO is to improve the efficiency of your organization. Remember, the number of days that inventory is sitting on shelves is wasting money. Since your cash is tied up in that inventory, your cash flow is hindered everyday you don’t sell. There are a couple mechanisms (listed below) you as the financial leader can put in place to measure and manage your DIO.
Maintain a perpetual inventory systems. You can’t manage what isn’t being measured.
Look at the volatility of sales of product lines. Then check to make sure if too much cash is being tied up in slow-moving inventory, as well as checking that you have enough availability of populate products to meet sales.
Pay bonuses for warehouse personnel based upon improving inventory turns. This serves as an incentive for those on the floor managing your inventory, in turn affecting your cash conversion cycle.
Accounts payable has the ability to be stretched if the relationship between your organization and your vendors are sound. This will help improve your cash flow.
Stretch your payables by:
Minimize fixed asset purchases when cash is tight. If asset purchase is necessary, then properly fund by matching asset financing with cash generation ability.
Renegotiate lease agreements.
Put your cash to work. One way to do that is to use sweep accounts to earn money on excess cash.
Seek additional investment capital when needed.
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