How would a reduction in the cash conversion cycle increase profitability

Cash flow is one of the key performance indicators for most businesses, but it only shows a snapshot of an organization’s health. The cash conversion cycle is a good indicator of how long cash is tied up in inventory before a product is sold and converted into income. A short cycle means you’re operating efficiently, minimizing unnecessary expenses, and producing a healthy amount of income. A long cycle means resources are being wasted housing unsold products and sales numbers are likely weak or slow.

What Is the Cash Conversion Cycle?

The Cash Conversion Cycle (CCC) determines the number of days it takes for a company to convert its inventory and other business resources into cash. Accounts payable teams also refer to this as the net operating cash cycle or the cash cycle.

Companies that operate efficiently tend to have lower CCCs. When businesses waste resources and the accounts receivable departments drag their feet on securing payments, they tend to experience larger CCCs. 

CCC is calculated by:

(Days Sales in Inventory) + (Days Sales in Receivables) - (Days Payables Outstanding)

The CCC taken a step further is the cash conversion score (CCS), which measures how capital spent has been converted into accounting rate of return (ARR), or the ROI of each dollar invested into a company. Simply put, the CCS shows much cash a business sees in return for each dollar spent.

Cash conversion score is measured by:

ARR / (Equity + Debt - Cash)

What’s a Quality Cash Conversion Cycle?

A good cash conversion cycle is a short one. If your CCC is a low or a negative number, that means the business’ working capital is not tied up for extended periods of time, and your business has greater liquidity. When your business has greater liquidity, it has greater agility to capitalize on irregular opportunities when they present themselves. 

Dropshipping is a recent, popular means of obtaining a low CCC utilized by online retailers. Dropshipping provides online retailers the ability to secure negative CCCs because they’re not maintaining inventory, they’re paid immediately upon the customer’s purchase, and the retailer doesn’t purchase their goods from the manufacturer until the customer has ordered.

If your CCC is a positive number, you do not want it to be too high. A positive CCC reflects how many days your business’s working capital is tied up while you are waiting for your accounts receivable to be paid. You may have a high CCC if you sell products on credit and have customers who typically take 30, 60, or even 90 days to pay you.

Simply put, CCC reflects how well a company is converting invested dollars into value. A cash conversion score of .25, for example, is considered “good” and shows a company that turns a dollar invested into 25 cents of recurring revenue. That is a healthy company that has a scalable model. 

Cash Flow Conversion: Shortening CCC

There are several ways you can shorten your business’s cash conversion cycle. For one, make sure your accounts receivable process is as efficient as possible. And as we mentioned previously, CCCs can vary across industries, company sizes, and business models. Regardless of your situation, consider these factors below to holistically improve your cash conversion cycle. 

Improve Cash Flow Management 

If you’re struggling with your cash conversion metrics, getting money in your hands quickly will help. Using automated A/R tools to send timely invoices, automatically sending follow-ups, and making it easy for customers to pay will decrease days payable outstanding.

With accounts receivable automation, you’re using fewer resources and increasing cash flow, which means businesses are able to be much more flexible in their decision-making.

Adjust Accounts Payable Periods

Of course, any business is spending as well as receiving payments. By optimizing the length of accounts payable outstanding, you’re giving yourself additional time to receive payments, increasing flexibility, and shortening the cash conversion cycle. By delaying your payables - even a few days - you’re maximizing the value of each dollar of your cash flow. This applies to any business model. The easiest way to do this is by lengthening the time accounts payable are outstanding - and the easiest way to do this is through an automated A/R solution. By setting up bill payments on a longer cadence - say 45 instead of 30 days - you’re giving your cash conversion more room to breathe.

Work with Your Customers

It would be nice if all customers were the same and paid on the same schedule, but that is, of course, not always likely. Understanding customers and applying empathy will get you paid quicker and, maybe, help retain a potential long-term customer.

Timing a customer’s billing cadence to complement their pay cycle reduces the days receivables are outstanding and decreases the potential of late payments. A robust customer payment portal helps here, allowing customers to set up their own payment schedules on their own time.

Modify Your Accounts Receivable

Depending on your business, requesting upfront payments - or at least a deposit - may be a viable option. Immediate payments are an easy way to increase cash flow and shorten the cash conversion cycle.

Leveraging the superior return on investment of an automated A/R solution is the most efficient way of improving cash flow. Larger changes like supply chain improvements or changing banking processes can take significant amounts of time and cause disruptions. Implementing an A/R solution is easy and has a lasting impact.

Optimize Your Inventory

If you maintain an inventory, the worst thing your product can do is nothing. Businesses must move inventory efficiently, building or purchasing only what they need and using all the tools available to keep the cash conversion cycle at a manageable level. This starts with purchasing only the inventory that you need and optimizing the inventory conversion cycle.

Whether they deal with raw materials or finished products, businesses should aim to have only what they absolutely need readily available. Adopting a fixed reorder system is advisable. This can be done by leveraging data derived from your accounts receivable solution. You should be able to mine that data for sales trends, time spent in inventory, and other key performance indicators that can help determine the ideal amount of inventory to have on hand. 

This is - of course - not possible if you have no inventory. The same basic idea still applies to service-based or software companies. Inventory optimization is based on the idea of consistently moving product, creating a steady flow of income without facing a self-inflicted financial burden. Businesses without inventory should look at Lifetime Customer Value - the average customer’s cash flow over the lifetime of their business relationship, minus the costs of acquiring them as a customer. 

Shortening Cash Conversion with Automated A/R

Shortening the cash conversion cycle means your business has the cash flow to do what it wants, be it increasing staffing, developing a new product, or delving into new markets. It’s a powerful, telling metric that can have a significant impact. Automated A/R tools are the best way of reducing the cycle. Implementing a solution designed to remove the complexity of A/R operations can positively increase the bottom line without significantly changing how you do business.

How does cash conversion cycle affect profitability?

What does a decrease in cash conversion cycle mean?

Is a lower cash conversion cycle good?

Why would a firm minimize its cash conversion cycle?