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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.

improving profitability instead of sales

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improving profitability instead of sales

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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.

reducing your cash conversion cycle

Strategic CFO Lab Member Extra

Access your Projections Execution Plan in SCFO Lab. The step-by-step plan to get ahead of your cash flow.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

reducing your cash conversion cycle

See Also:

Continuous Accounting: The New Age of Accounting

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Operating Cycle Analysis

See Also:
Operating Cycle Definition
days inventory outstanding
Cash Cycle
day sales outstanding
days payable outstanding
Financial Ratios

Operating Cycle Formula

Complete operating cycle analysis calculations simply with the following formula:

Operating cycle = DIO + DSO – DPO

Where

DIO represents days inventory outstanding

DSO represents day sales outstanding

DPO represents days payable outstanding

Operating Cycle Calculation

Calculating operating cycle may seem daunting but results in extremely valuable information.

DIO = (Average inventories / cost of sales) * 365 DSO = (Average accounts receivables / net sales) * 365

DPO = (Average accounts payables / cost sales) * 365

For example, what is the operating cycle of a business? A company has 90 days in days inventory outstanding, 60 days in days sales outstanding and 70 in days payable outstanding. See the following calculation to see how to work it out:

Operating cycle = 90 + 60 – 70 = 80

In conclusion, it takes an average 80 days for a company to turn purchasing inventories into cash sales. In regards to accounting, operating cycles are essential to maintaining levels of cash necessary to survive. As a result, maintaining a beneficial net operating cycle ratio is a life or death matter.

Resources

If you want statistical information about industry financial ratios, then go to the following websites: www.bizstats.com and www.valueline.com.

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 Analysis

Strategic CFO Lab Member Extra

Access your Projections Execution Plan in SCFO Lab. The step-by-step plan to get ahead of your cash flow.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Operating Cycle Analysis

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