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Beware of the J Curve

J Curve

An increase in sales sounds great! Right? But have you ever heard about the colloquialism of growing out of business? Growth requires cash flow, but sometimes, quick growth doesn’t allow you to keep up. If a company is run by leaders with sales backgrounds, they will be more focused on the growth than supporting that growth. Sometimes, it’s difficult for a company to sustain growth, especially if they aren’t collecting receivables quickly. This leads to some companies turning away clients. The analysis and forecasting of working capital is crucial in a high growth situation.

What is the J Curve?

A j curve is an initial loss followed by an exponential growth. This curve is used in the medicine, political science, economics, and in business. The quicker you grow, the quicker your burn through cash.

Cash is king, net working capital which is current assets less current liabilities is an indicator of the companies ability to meet short term obligations. In a high growth situation you will burn through net working capital and need to manage it carefully.

Looking to improve cash flow in your business? Click here to download our 25 Ways to Improve Cash Flow and get an invitation to join our SCFO Lab.

J Curve Effect

Initially, there is a decrease in sales, then there is a sudden growth. This growth ties up cash flow. Inventory requires significant cash to supply the demand. But if the company invoices the customer, then there is a risk of not being paid for 15, 30, or 60 days. Even if the company collects the cash up front, it doesn’t always align with when payments are due.

Let’s look at the Cash Conversion Cycle!

Cash Conversion Cycle (CCC) =Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payable Outstanding (DPO)

There are three things that impact the cash status for a company: sales, inventory, and payables. In other words, revenue, COGS, and overhead. If one of those are out of balance, then profitability will be impacted. If they are out of balance and net working capital is on a decline, then you are really in trouble. When you experience a j curve effect, you will see all increase in all areas with more emphasis on payables.

When J Curves Are Likely to Happen

There a couple instances where j curves are more likely to happen. Fasting growing firms and startups are two examples where we frequently find j curves in action.

Startups

Startups typically begin out of a need seen in a market. At some point, their product/service clicks with the market and they take off. This is great for the start up! But if the company doesn’t have liquidity or cash, then it will not be able to support the growth. In addition, you risk the quality of your product/service, dealing with legal issues associated with poor quality, and having bad reviews. For example, a startup finally hits the market at the right time with the right product. Sales boom and the entrepreneur is ecstatic! But they have no processes, they are buying materials for the product without thinking strategically, and are only looking at the sales. While sales were booming, they were buying everything on the company’s Amex. At the end of the month, the fees and lack of consideration for the timing of purchase outweighed the increase in sales. They ended up in the red.

Fast Growing Firms

Fast growing firms also see the same issues that startups deal with. In addition, fast growing companies tend to grow overhead quickly or lose sight of how big it is actually getting – larger operations, more employees, bigger reputation, etc. For example, $1 Billion fitness company Beachbody released a new fitness program earlier this month. Unfortunately, they did not forecast the sales accurately and were not prepared for the amount of sales they received. What could be a great opportunity turned into a scramble to deliver on the equipment needed for a new fitness program. As a result, they sent other similar products as a temporary solution. Customers could ask for the product that they ordered and they would be put on a waitlist – essentially asking for 2 products for the price of one.

Manage Your J Curve

J curves need to be managed because they can easily get out of control, leaving a large mess to clean up. Some of the factors you need to look at when managing your j curve include assessing the type of sales you are having and the ideal sales, the timing of when you purchase materials, and managing (retaining) your talent. Remember, the quicker you grow, the faster you run out of fuel.

Types of Sales

There are good sales, and then there are bad sales. We’re talking about the types of products/services you’re selling and who you are selling to. If you accept both good and bad sales, you are not managing your j curve effectively. Maintaining healthy profit margins in a high growth situation is also critical.  Sometimes, it can be more productive and profitable to fire a particular customer than take their money.

Timing of Purchases

Ever had to purchase something without having cash in your pocket? If you’re like most people, then you would defer that payment until you have cash. But companies disregard their habits in their personal lives… Sales means cash, right? Wrong. Work with your vendors to delay payments until you have cash in the bank.

Talent Management

Your talent is one thing you need to look at when managing your j curve. The reason is because with increased growth comes increased stress. If you are not taking care of your employees, then employee productivity and morale is going to decrease and eventually, turnover. We all know that high employee turnover is a cause of bleeding cash in you business. First, there’s decreased productivity that makes product produced or sale made that much more expensive. Then, there’s severance and continuing benefits for a certain amount of time. Finally, there’s the expensive hiring process that potentially includes staffing, recruiting, hiring, training, etc.

Effective Business Planning with a J Curve

Focus on the cash flow and profitability of your company. We show every company that we work with in our consulting practice and coaching workshops how to improve its profits and cash flow. When it comes down to it, that’s all the business is made up of. And every company, regardless of whether you are in a fast growth company or not, needs to effectively plan using cash flow forecasts and reports, flash reports, and flux analysis. If you are seeking more ways to make a big impact in your company, download the free 25 Ways To Improve Cash Flow whitepaper to find other ways to improve your cash flow within 24 hours.

j curve

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How Growth Affects Cash Flow

Growth is great! Whether it is expanding into your third country or tapping into a new market, it’s an exhilarating process (especially for the entrepreneur). But it can also result in a crisis… You can’t fulfill orders; processes are being thrown out the door to just get it done; inventory isn’t leaving the warehouse. Growth can result in a disaster. When a company is growing at any speed, there are often growing pains that come with it. Over the past 20+ years, The Strategic CFO has witnessed and been a part of some incredible turnarounds that started from a few simple steps of improvement. The #1 growing pain stems from cash. Or, actually the lack of it.  We often forget how growth affects cash flow, but it has huge repercussions if you are not watching it carefully.

Growth Affects Cash Flow

What Happens When a Company Grows

When a company grows, the first visible thing that happens is cash gets tight. It’s very common for your marketing and sales team to see grow as only a good thing; nothing bad could be caused from growth. But when more sales come in, more employees are needed, more offices are required, more inventory is purchased, money can very quickly fly out the door. We say it frequently because it’s true: cash is king.

As you gear up for growth or are in the early stages of growth, also iron out some of the issues that may grow into problems as the company grows. For obvious reasons, start addressing any issues that impact the cash flow of the company. Then address other issues including management, accounting, product development, and labor.

Another thing that normally happens is that we are so excited about growth, and maybe cash is controlled, but we forget about controls, specifically internal controls.  Money is flowing and product is flying off the shelf, but no one is watching what may be lose ends.  Such as in a manufacturing scenario, material is being ordered as fast as you can get it and raw materials are being converted to finished goods. But maybe waste is also going through the roof because no one is watching that.  Or maybe tools are mysteriously disappearing from the shop, or maybe your margins are actually suffering because your indirect costs have grown more than anticipated.  The lack of having process and controls in place can lead to the mentioned issues, thus also leading to squeezing cash.  Because ultimately, it all results in cash or consumption of cash.

Growth Affects Cash Flow

Growing Too Quickly?

If you are in a company that is growing too quickly, it may be time to get some capital. There are several types of capital that you can acquire to fund your rapid growth. Ultimately, there are three ways to get capital.

  1. Debt
  2. Equity
  3. Or a mixture/combination of debt or equity, or debt that can convert to equity

Giving up equity is the most costly way to raise capital because as your grow you have given up some of the upside. The sources of either debt or equity include and are not limited to the following:

At The Strategic CFO we can help you analyze the different cost of this capital and the most efficient structure for your business.

Start-ups, development of new products, etc. often require a good amount of working capital to support the rapid growth for those products or services to have a steady foothold in the marketplace. Consequently, they require a significant amount of cash and leadership for it to be catapulted into success. If this is you, start the cash flow improvement strategies early. Make it part of your culture and processes. The key is to manage your cash effectively so that each dollar can be stretched to the max. Download our free 25 Ways to Improve Cash Flow guide to start implementing tested and successful cash flow improvement strategies into your company.

Growth Affects Cash Flow by Absorbing Cash

If you haven’t figured out by now, growth has a way of absorbing cash. When a company wants to increase sales, it requires fuel – cash. As the financial leader of your company, shift your focus on improving profitability and providing fuel for your sales team to grow the company. While your CEO needs to grow the company, he or she needs a wingman to lean on. You are that wingman. Instead of acting as a CFnO (say it like CF No), provide a path for your CEO to grow the company. Guide them in your new cash flow improvement strategies.

Don’t know where to start in improving your cash flow? Click here to download our 25 Ways to Improve Cash flow and get an invitation to our SCFO Lab – the premier financial leadership coaching platform.

Growth Affects Cash Flow

Cash Conversion Cycle (CCC)

As you continue to look how growth affects cash flow, start by analyzing your cash conversion cycle. Simply, it is the amount of time that you are able to convert processes, resources, etc. back into cash. There are some simple steps to reduce your Cash Conversion Cycle (CCC) or operating cycle, but let’s see what it is and how you can use that to improve your cash flow.

What is the Cash Conversion Cycle?

The Cash Conversion Cycle (CCC) calculates the amount of time it takes to convert resources into cash flow. To calculate your CCC, use the following equation:

CCC = DIO + DSO – DPO

DIO stands for Days Inventory Outstanding. DSO stands for Days Sales Outstanding. And finally, DPO stands for Days Payable Outstanding. By using the CCC, you will be able to identify areas of improvement.

For example, if you are collecting receivables every 45 days, you may have an opportunity to reduce that to 30 days. By collecting receivables 15 days earlier, you will not be in as large of a cash crunch because that cash is in the bank 30 days after the service is rendered versus 45 days. To calculate DSO, use the following formula:

DSO = 365 * (Average Accounts Receivable / Total Credit Sales

How to Improve Your Cash Flow

There are several ways to improve your cash flow using the Cash Conversion Cycle. Some of these include improving collections (A/R), invoicing quicker, obtaining deposits faster, extending vendors so that you can pay later, and reduce the amount of inventory stored. For example, a few of our clients are in the oil & gas industry. When the oil & gas industry takes a downward turn, we are impacted because they cannot pay us as quickly, but they need us more than ever. One of the tactics we put into practice to improve our cash flow was to invoice within 24 hours. Our clients were being trained to respond to us quicker and pay our invoices. Therefore, we were then able to do more to help them.

There are so many other ways to improve your cash flow, especially in times of growth when cash is tightest. If you are seeking more ways to make a big impact in your company, download the free 25 Ways To Improve Cash Flow whitepaper to find other ways to improve your cash flow within 24 hours.

Growth Affects Cash Flow

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Growth Affects Cash Flow

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Improving Profitability – Fuel for Growth

How do you focus on improving profitability instead of just boosting sales? 2016 wasn’t the best year for some of us, but the new year provides a perfect opportunity to reassess goals. An entrepreneur’s natural tendency is to increase sales in order to balance out last year’s financials. But what many entrepreneurs fail to consider is are those sales actually profitable?

There’s Only So Much Cash

Why is improving profitability instead of simply increasing sales so important? Because, believe it or not, you can actually grow yourself into bankruptcy.

Huh?

Many are quick to say that more sales is the solution – however, there are a lot of factors you have to consider before you start selling everything. One of the most important metrics you must know is your cash conversion cycle. The cash conversion cycle is the length of time it takes a company to convert resource inputs into cash flows.

Cash Conversion Cycle Formula:

Cash Conversion Cycle (CCC) =Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payable Outstanding (DPO)

– or –

CCC = DSO + DIO – DPO

improving profitability instead of salesDaily Sales Outstanding (DSO): This metric measures the number of days it takes to convert your receivables into cash. Ideally, the faster you can collect, the faster you can use the cash to fuel growth.

Days Inventory Outstanding (DIO): This is an indicator of how quickly you can turn your inventory into cash. Reducing DIO is good. If all of your cash is tied up in inventory that isn’t moving, then you might have a problem.

Days Payable Outstanding (DPO): This measures how quickly you are paying your vendors. If you are consistently paying your vendors more quickly than you are getting paid by your customers, then you risk running out of cash. If your vendors aren’t giving you a discount for paying early, then why are you paying early? If you have 30 days to pay, then why pay on the second day? Use that cash for the other 28 days you have for other vendors who offer you discounts or to fuel growth.

Managing the cash conversion cycle is a key way you can enable your company to grow.  And we all know how fond entrepreneurs are of growth…

(Click here to learn How to be a Wingman and be the trusted advisor to your team.)

Cash is like Jet Fuel

Often, entrepreneurs (especially those from a sales background) focus on improving sales. What many fail to realize is you can actually sell yourself into bankruptcy.

Let’s compare a business to a jet. If a jet is moving at a constant pace, then the fuel used to power the jet runs out at a constant pace. From a business perspective, if the sales in a company are constant, then the cash and assets required to fuel the company is also constant and predictable.
improving profitability instead of salesHowever, if a company decides to increase sales, then this requires more “fuel” or cash.

But if an entrepreneur decides to increase sales to a greater degree than cash flow, almost vertically, then the business may run out of fuel (cash) and can ultimately crash and burn.
improving profitability instead of sales

The quicker you grow, the quicker you burn cash.

improving profitability instead of sales

Sustainability is Key

The sustainable growth rate of a company is a measure of how much a company can grow based upon its current return on assets. The sustainable growth rate of a company is like the wind turbine of a jet. Naturally, the wind turbine gives the jet a 5-10% incline. But what if you want to grow to 25%? Or 50%?

To grow faster than your return on assets, you’ll need to take on additional debt or seek equity financing. Either you pay for it, or someone else does. To avoid increasing debt or giving up control, it’s important to maximize your current asset velocity (think managing CCC) and make sure your sales are profitable.

(Be more than overhead. Be the wingman to your CEO by increasing cash flow!)

How to Grow Your Business

If you want to grow your business, there are a couple of things you can do:

(1) Increase your profitable sales. This means deciding which projects have the lowest risk, but highest reward for your business. Time is money, so which customers are worth your time? In exploring this, you might have to conduct some market research for your target market.

For example, if you have some customers who are slow to pay, they’re straining your liquidity. Although it may be difficult, you might have to fire some customers and focus your resources on customers that aren’t such a drain.

(2) Increase capital. Capital is the funding you need to grow the business. Capital can be an investment from an outsider, or it can be cash generated internally by increasing cash flows and maximizing profitability.

Internally: A company can increase cash flow by managing the cash conversion cycle. Collect your receivables faster and manage inventory levels and payables. It is a good idea for a company to grow as organically as possible, meaning growing cash internally.

Externally: If you’ve tightened up your CCC as much as possible, it might be necessary to look for outside sources of cash. However, having external sources of cash is a trade-off; you’ll have debt with a bank, and you might have to give up part of your company to investors (depending on the terms).

Conclusion

So when your business owner says, “let’s increase sales!”, remember focus on making profitable sales. Look at improving the Cash Conversion Cycle to make the most of your internal resources.  Consider outside financing when/if your existing return on assets won’t get you where you want to be.

Don’t crash and burn – make sure your company has the fuel it needs. Your business owner is looking to you to help them grow their business. To learn how to do it, access the free How to be a Wingman whitepaper here.

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Reducing Your Cash Conversion Cycle

reducing your cash conversion cycle

What is the impact of reducing your cash conversion cycle?  Is it worth the effort?  In order to quantify the benefit of reducing your cash conversion cycle, it’s important to understand exactly what it is. 

Definition of Cash Conversion Cycle

Cash Conversion Cycle is a metric that expresses the length of time, in days, that it takes for a company to convert resource inputs into cash flows (also known as the cash cycle or operating cycle)

Formula of Cash Conversion Cycle

Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)

– or –

CCC = DIO + DSO – DPO

Put simply, it measures how quickly an unfinished product can be turned into cash.

Why Reduce Your CCC?

Now that we understand the components of the CCC, let’s look at what kind of impact changes in each component can have.  Consider the following example:

cash conversion cycle

In this example, a company with $25 million in sales volume (with gross margin of 35%) could free up over $2 million in cash by collecting receivables one week sooner, turning inventory once more per year and stretching payables by one week.  At a cost of capital of 5.25%, it would also see an additional savings of over $100K in interest fall straight to the bottom line

Plug in the variables for your business and see what kind of improvement in the cash conversion cycle you could expect by tightening up your collections, inventory or payables processes. The results may surprise you.

Who Should be Looking at This?

Certainly anyone in the organization with access to the data can do the calculation, but the CFO is responsible for making things happen.  To be able to do this, the CFO has to be plugged into what’s going on in operations as well as finance in order to identify areas of improvement.  This is one of the many ways a CFO can do more than simply crunch the numbers by providing strategic opportunities for growth through savings.

What could your company do with an extra $2 million in liquidity and $100K in profits? 

Learn how to apply concepts like this in your career with CFO Coaching.  Learn More

For more ways to add value to your company, download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash.

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See Also:

Continuous Accounting: The New Age of Accounting

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Operating Cycle Definition

Operating Cycle Definition

The Operating cycle definition establishes how many days it takes to turn purchases of inventory into cash receipts from its eventual sale. It is also known as cash operating cycle, cash conversion cycle, or asset conversion cycle. Operating cycle has three components of payable turnover days, Inventory Turnover days and Accounts Receivable Turnover days. These come together to form the complete measurement of operating cycle days. The operating cycle formula and operating cycle analysis stems logically from these.

The payable turnover days are the period of time in which a company keeps track of how quickly they can pay off their financial obligations to suppliers. Inventory turnover is the ratio that indicates how many times a company sells and replaces their inventory over time. Usually, calculate this ratio by dividing the overall sales by the overall inventory. However, you can also calculate the ratio by dividing COGS by the average inventory. Finally, the accounts receivable turnover days is the period of time the company is evaluated on how fast they can receive payments for their sales. In conclusion, the operating cycle is complete when you put together all of these steps.


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Operating Cycle Applications

The operating cycle concept indicates a company’s true liquidity. By tracking the historical record of the operating cycle of a company and comparing it to its peers in the same industry, it gives investors investment quality of a company. A short company operating cycle is preferable. This is because a company realizes its profits quickly. Thus, it allows a company to quickly acquire cash to use for reinvestment. A long business operating cycle means it takes longer time for a company to turn purchases into cash through sales.

In general, the shorter the cycle, the better a company is. Tie up less time capital in the business process. In other words, it is in a business’ best interest to shorten the business cycle over time. Try to shorten each of the three cycle sections by a small amount. The aggregate change that comes from the shortening of these sections can create a significant change in the overall business cycle. Thus, it can consequently lead to a more successful business.

operating cycle definition

See Also:
Operating Cycle Analysis

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Operating Cycle Definition

See Also:
Operating Cycle Analysis

Operating Cycle Definition

The Operating cycle definition establishes how many days it takes for a company to turn purchases of inventory into cash receipts from its eventual sale. It is also known as cash operating cycle or cash conversion cycle or asset conversion cycle. Operating cycle has three components of payable turnover days, Inventory Turnover days and Accounts Receivable Turnover days. These come together to form the complete measurement of operating cycle days. The operating cycle formula and operating cycle analysis stems logically from these. To be more specific, the payable turnover days are the period of time a company keeps track of how quickly they can pay off their financial obligations to suppliers.

The next step, inventory turnover, is the ratio that indicates how many times a company sells and replaces their inventory over time. Usually, calculate this ratio by taking the overall sales and dividing it by the overall inventory. However, calculate the ratio by dividing the cost of goods sold by the average inventory. The final step, the accounts receivable turnover days, encase the period of time in which the company is evaluated on how fast they can receive payments for their sales. As said before, when you put together all of these steps, the operating cycle is complete

Operating Cycle Applications

The operating cycle concept indicates a company’s true liquidity. By tracking the historical record of the operating cycle of a company and comparing it to its peer groups in the same industry, it gives investors investment quality of a company. A short company operating cycle is preferable since a company realizes its profits quickly. It also allows a company to quickly acquire cash to use for reinvestment. A long business operating cycle means it takes longer time for a company to turn purchases into cash through sales.

In general, the shorter the cycle, the better a company is. This is since less capital is tied up in the business process. In other words, it is in a business’ best interest to shorten the business cycle over time. The easiest way is to shorten each of the three cycle sections by, at least, a small amount. The aggregate change that comes from the shortening of these sections can create a significant change in the overall business cycle. As a result, it can consequently lead to a more successful business.

For more ways to add value to your company, download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash.

Operating Cycle Definition

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Operating Cycle Definition

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Cash Cycle

Cash Cycle Definition

A cash cycle is defined as the time it takes a company to turn raw materials into cash. It is also a common concept in any business which processes materials. Also known as the cash conversion cycle, it refers to the time between purchasing the raw materials used to make a product and collecting the money from selling the product. It also functions well as a measure of liquidity: how easily can unfinished product be turned into cash.

(Find out if reducing your cash conversion cycle is worth the effort!)

Cash Cycle Explanation

Cash cycles are typically measured in days. A shorter cash cycle is better than a longer cash cycle. A company with a shorter cash cycle has more working capital and less cash tied up in inventory and receivable accounts, which means it is less dependent on borrowed money. Cash cycle depends largely on operational efficiency. Factors that effect the cash cycle include labor efficiency, the quality of raw materials, quality of equipment, efficiency of management structures for processing materials, economic and market influencers, and more.

Cash Cycle Formula

Simply, the cash cycle calculation can be performed with:

Inventory to product conversion time + receivables collection time – Payables payment time

When measured in years the cash cycle equation is:

Average inventory / (cost of goods sold / 365) + Average AR / (Sales / 365) + Average AP / (COGS / 365)

Cash Cycle Example

For example, Ronald owns a custom gun smithing service. As a sole proprietor, Ronald has never paid much attention to creating financial statements as long he could pay his bills. Due to the recent change in national administration and economic state, he has had to change this view to accommodate increased demand for his services. Ronald is curious how long it takes him to convert materials to income. With this he will attempt to increase efficiency as well as production capacity. Studying his cash conversion cycle provides insight into his work processes as well as the liquidity of his business operations.

Ronald will begin by completing the process in a simple way. He begins keeping a pad close while he works to monitor how long it takes him to make a product.

Then, Ron looks in his quick books to find out the average amount of time it takes him to be paid. He has never been much of a collections agent but is still a little disturbed by how long it takes customers to pay. Ron puts his heart and soul into his work and feels he deserves better.

Finally, Ronald looks back to see how long it takes him to pay his suppliers. Ron has never pushed for credit terms and realizes that he has always paid vendors upfront.

Improve Your Cash Cycle

Ron finds a cash cycle template online to simplify his calculation. Ron’s eyes are opened from this experience. His method of doing business as a sole proprietor was satisfactory but Ron will have to make some changes to accept the success that he can freely receive. He knows he is ready for the change but considers hiring a business consultant to make sure he does the job right the first time. He takes a moment to think about the future and smiles; Ronald is ready for the challenge that awaits him.

For more ways to improve your cash cycle, download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash.

cash cycle

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cash cycle

See Also:

Days Sales Outstanding (DSO)
Days Payables Outstanding (DPO)
Daily Cash Flow Forecast
13 Week Cash Flow Report
How to Create Dynamic Cash Flow Projections
Days Inventory Outstanding (DIO)

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