Now, the CFOs around the globe are trying to improve internal liquidity, as it is one of the factors that are completely in the company’s own hands. Healthy cash flow is crucial for the business’s efficiency and long-term success. The cash conversion cycle or CCC is the standard measure of how healthy is the working capital. Let’s see how your business can easily shorten it.
Strong sales and profit figures historically indicated the companies’ success. However, the new paradigm has shown that balance sheet discipline shouldn’t be neglected. The figures speak for themselves- almost half a trillion ($460 billion ) is tied up as working capital of the S&P 1500 companies in 2018.
What is CCC and How to Measure It?
The best way to measure the current state of affairs is to use working capital management ratios.
The cash conversion cycle (CCC) indicates how quickly the business can transform its purchases into cash.
CCC= Days Inventories Outstanding (DIO)+ Days Sales Outstanding (DSO)- Days Payables Outstanding (DPO)
DIO= Average Inventory/Cost of Goods Sold * 365 days
DSO= Average Accounts Receivable/Total Credit Sales * 365 days
DPO=Average Accounts Payable/Cost of Goods Sold * 365 days
The first two components are associated with the assets, while the DPO is the only ratio depending on the outgoing payments, therefore is negative.
The measure tells how quickly the firm’s investment into inventories will take to return in cash. The shorter the cycle, the better, as it means the company is not locking its resources in the inventories or is waiting long for collecting payments from clients.
The cash conversion cycle is less relevant for software (SaaS) companies, as they are not investing in inventories. Rather, they should measure the cash conversion score (CCS). The CCS tells us how much the company receives for every invested dollar.
CCS= Accounting Rate of Return (ARR)/ Equity+ Debt-Cash
The cloud companies’ CCS of 0.25 to 0.5 is considered good, while 1 would be perfect.
What is Considered Good CCC?
According to the J.P. Morgan Study, the average cash conversion cycle for the S&P 1500 companies varied between 61 to 68 days between 2011 throughout 2018. The S&P 1500 consists of very large companies, including pharma (where CCC was around 150 days) and airlines, where CCC was negative due to the prepayment nature of the business model.
The different annual surveys by Hacket Group of 1000 largest U.S. non-financial companies have shown an average CCC of 33 days because they look at the different industries like internet retail, or beverages and food.
No matter what industry the business is working in, it is important to understand how to respond quickly to the cash flow challenges, especially, during crises. The COVID-10 pandemic has negatively affected the CCC mainly due to a fall in sales and longer collection periods. Below are the three most important steps that the business can undertake to improve its CCC measure.
Automating the Accounts Receivable (AR) is the most simple, cost-efficient way to improve the Days Sales Outstanding. The shorter the DSO, the better the CCC according to the formula. Shorter DSO, in turn, depends on efficient AR management. Kolleno Cloud-based AR software can be integrated with your accounting software, and complement it in the perfect way.
The AI-powered software will prepare the invoices once the sale was completed using your unique corporate style. If the invoice is overdue, the client will automatically receive a reminder. The customer will receive the message via the most convenient communication channel using the appropriate tone of voice. Moreover, the client will be able to choose from several payment options or even will receive the payment plan. Pro-active invoice management will result in faster payments and eventually in a shorter cash conversion cycle.
The AR automation is not only saving your staff valuable time but also will be the right step towards digital transformation.
Optimise Inventories Management
If the Days Inventories Outstanding is long, it will make your CCC long as well. It is important to strategically plan how many inventories your business orders or produces. Otherwise, the inventories will be waiting for long in the warehouse, take up space, and even become obsolete.
In order to effectively manage the levels of inventories, it is important to understand the sales. It is useful to establish a good relationship with your large customers and find out in advance what is their approximate level of order in the near future. On the other hand, your business can improve the relationship with its suppliers and negotiate terms like last-minute orders, so you do not have to hoard on the inventories and order new one as you need them. Another possibility is to negotiate better minimum order quantities, so you do not have to order large bulk of inventories.
Optimise Accounts Payable
Unlike the first two ratios, Days Payable Outstanding inversely impact the CCC. So the longer DPO, the shorter the CCC, because the longer your business holds on the cash to pay its bills, the better. So, it is advisable to set up your bill payments in line with deadlines. Paying the bill 5 days later can improve the cash flow of the company. Read carefully the deadline and terms, availability of early-payment discounts, and etc.
The J.P. Morgan study has shown that the larger companies had the CCC of 54 days, as opposed to 75 for smaller businesses. This was mainly due to the longer cycle of days payables outstanding (DPO) of 13 days. The better bargaining power with their suppliers explains the longer period to pay the bigger companies’ bills. Due to their size, large businesses can negotiate better terms of payment. Moreover, 53% of all studied companies who improved their CCC 67% done so thanks to improving their DPO.
Moreover, there is evidence that some micro and small businesses had to pay their suppliers in advance, which negatively impacted overall CCC. So, one of the key elements of short CCC is to negotiate with your suppliers better payment terms.
If your business is looking for ways to improve the working capital performance, contact Kolleno and see how our digital tools can improve your liquidity.