Unlocking Cash Flow
How optimising your Cash Conversion Cycle can transform your business
To Investors,
Economically, times are hard for businesses. In South Africa for example, business confidence has been trending lower since 2021; inflation remains sticky at 5.2% vs the South African Reserve Bank’s target of 4.5% (and inflation has been above that target since April of 2021); since Q4 of 2021 interest rates have gone from 3.5% to 8.25%; and the lending rate has gone from 7% to 11.75%.
If you’re running a small business, you’ll likely be feeling these pressures more than a more mature business because a small business is less likely to have the necessary infrastructure in place to weather economic hardships.
Well, what can you do?
Answer: streamline operational inefficiencies.
One vital tool to use is measuring and improving your business’s cash conversion cycle (CCC).
The CCC measures how long it takes for a company to convert its investments in inventory into cash flow from sales.
To help me understand the CCC better I’ve created a short case study for a company called ShoeCo, a mid-sized manufacturing company that produces high quality shoes…
ShoeCo faced significant cash flow challenges - despite increasing sales…
The first red flag would be “how do you have cash flow issues when you keep selling more shoes?”
The next question would be: “what is the company doing with its cash?” and measuring the Cash Conversion Cycle will help answer that question.
The CCC is made up of three main components:
Days Inventory Outstanding (DIO): The average number of days the company holds inventory before selling it.
Days Sales Outstanding (DSO): The average number of days it takes to collect payment after a sale.
Days Payable Outstanding (DPO): The average number of days the company takes to pay its suppliers.
For ShoeCo, the metrics were as follows:
DIO: 50 days (average time inventory is held)
DSO: 40 days (average time to collect receivables)
DPO: 30 days (average time to pay suppliers)
The CCC formula is:
CCC = DIO+DSO-DPO
So for ShoeCo:
CCC = 50+40-30 = 60 days
This means it takes ShoeCo 60 days to convert its investments in inventory into cash flow.
A lot can happen if your cash is tied up for 60 days.
If ShoeCo’s current operational processes tie up capital for 60 days this will lead to cash flow problems because ShoeCo’s ability to reinvest in growth opportunities, pay off debt, or manage unforeseen expenses is limited.
So how can ShoeCo improve its CCC?
Optimising Inventory Management:
Just-In-Time (JIT) Inventory: implementing JIT can help reduce the time inventory sits in warehouses, lowering the DIO, and at the same time reducing storage costs for ShoeCo.
Demand Forecasting: enhanced forecasting methods can allow for better inventory planning and reduced excess stock.
Accelerating Receivables:
Incentives for Early Payment: offering a discount to customers for early payment can improve the DSO because customers will settle their credit accounts faster.
Streamlining Invoicing Processes: implementing electronic and automated invoicing systems also reduces delays and improves cash collection.
Extending Payables:
Negotiating Better Terms with Suppliers: renegotiating to increase payment terms with key suppliers will extend the DPO without harming supplier relationships.
Leveraging Trade Credit: utilising trade credit can allow ShoeCo to conserve cash while maintaining operations.
Within a year, ShoeCo saw significant improvements:
DIO: Reduced to 35 days
DSO: Reduced to 30 days.
DPO: Extended to 45 days
The new CCC for ShoeCo was:
CCC = 35+30-45 = 20 days
This 40-day improvement from a 60-day cash conversion cycle to a 20-day cycle meant ShoeCo had more liquidity to invest in new projects, improve operations, and navigate economic uncertainties.
For any business, but especially smaller businesses, it's important to monitor and analyse the cash conversion cycle by regularly tracking this metric to identify inefficiencies and areas for improvement. Key learnings are to 1) optimise inventory management by reducing excess inventory and improving turnover rates; 2) accelerate receivables through enhancing cash collection processes to improve liquidity; and 3) manage payables strategically by balancing paying suppliers on time with extending payment terms to optimise cash flow.
I hope you enjoyed this letter.
One the journey to becoming a master capital allocator - one lesson down, a billion more to go.
Respectfully,
-Mansa
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Disclaimer: this note is not financial advice and is for informational and entertainment purposes only. We may hold positions in the companies discussed. Do your own research.