“Transforming a revenue culture into a profit culture is no small task. All functions, from sales to marketing to operations – must join in the effort. But once your firm’s processes and metrics are based on an integral perspective, you’ll be one step closer to a simpler and more profitable business.”
—HBR Guide to Finance Basics for Managers
Harvard Business Review Press
Much of a successful business practice involves past- due collections, but not the cash conversion cycle; that is, how soon you get your shop’s money – the working capital spent for materials – back into your bank. Harvard Business Review (HBR) writers Karen Berman and Joe Knight, in their book Financial Intelligence for IT Professionals, offer advice on the cash conversion cycle, the amount of time occurring between the manufacturing and collection cycles.
Their principle is straightforward: Accelerate the turnaround time between the buying of materials for a contracted sign and the day you get paid for the sign. Essentially, until paid, your materials cost becomes an unsecured loan to the sign buyer and, odds are, your estimate included profit but not interest on that materials-cost “loan.”
In one sense, the (nonexistent) loan interest is a cost of doing business; however, knowing the cash conversion cycle is vital because an interval reduction means you get your money back sooner. Thus, a faster turnaround enhances your shop’s cash flow.
Generally, a positive cash flow indicates the company is profitable because there is – should be? – enough cash flowing through the system to pay the bills and still have end-of-month money in the bank.
Berman and Knight break the cash- conversion cycle into four stages: raw materials purchased, payment for those materials (which could occur days later), sale of finished goods and cash collected on the sale. They’re saying that once you buy materials for an in-process job, you have, in effect, extended a line of credit to your client, a line that remains until the transaction is paid. (Paid as in cash-received paid, not accounts-receivable paid.)
The HBR writers outline three critical categories for determining a cash conversion cycle: days sales outstanding (DSO), days in inventory (DII) and days payable outstanding (DPO).
The DSO average tells of your average collection period and reveals how well your accounts receivable are handled. You calculate the ratio like this: Accounts receivable / average sales per day = DSO ratio. You can change the time element: DSO ratio = accounts receivable / 365 days (for annual sales), to calculate the relationship between outstanding receivables and credit account sales achieved over a given period. In general, this figure reveals how long, on average, it takes your accounts to pay up. A higher number says your collections are lagging and your cash flow could be improved.
The DII figure speaks of average days taken to convert inventory (materials) into a paid sale; it reveals the number of days your money is tied up in inventory.
The DPO gives a company’s average payable period, meaning, how long it takes to pay its trade creditors. DPO is critical because it addresses the equilibrium between a company’s money in the bank and the time it takes to pay its bills. Although money in the bank is good, your creditors won’t enjoy slow payments and payment tardiness could backfire should you need special favors or a new credit approval. However (and conversely), extending the DPO is one way to handle a temporary cash shortfall.
HBR’s formula for determining how fast your company regains its cash outlay is this:
Cash conversion cycle = DSO + DII – DPO
Their example looks like this:
54 days + 74 days – 55 days = 73 days as the cash conversion cycle.
Berman and Knight say knowing this time figure is important because with it, you can determine how many days the process takes and then understand how many days (for that project) your company’s cash is tied up. In their example, 73 days ends the accounts receivable period, and, thus the cost conversion cycle. Berman and Knight also say you can affect the cash conversion cycle by decreasing the DSO, decreasing inventory and increasing the DPO. Of course, you can also lessen any order risk by requiring a deposit.
Definitively, you can figure all this on the back on an envelope, but a better system is to include such figures as part of each job costing file, or as an overall analysis in your monthly accounting recap.