When’s the last time you paid attention to your company’s cash conversion cycle? Adam W Silver offers insight on how this often-ignored metric can help improve the management of working capital and generate more cash and flexibility for your business.
It’s no secret that having more cash on hand can help accelerate a company’s performance. Not only does a cash surplus give businesses the ability to support short-term operations, but it creates choices and fundamental flexibility. But how do companies generate cash? The short answer: an improved Cash Conversion Cycle (CCC). In other words, the CCC is the engine that can help boost business operations; the key question, however, is how do you kickstart and fine-tune this engine?
In 2013, Cole Haan, the apparel and footwear retailer, was downgraded by Moody’s with “very high credit risk.” Despite consistent online sales growth, the company was expected to deliver negative cash flow. By June 2017, Cole Haan reported free cash flow of $22 million, up more than $12 million, largely on the back of better working capital management and efforts at improving profitability. This stands in stark contrast to the Toys “R” Us rapid descent into bankruptcy last year.
As you can see, reducing the CCC is a key mechanism through which to improve the management of working capital and to generate cash. Although the idea of the CCC is rooted in business school basics, working capital doesn’t appear on the income statement and doesn’t directly impact earnings or operating profit. As a result, the CCC is frequently a secondary strategic concern, even at large companies—but it shouldn’t be.
Understanding the cash conversion cycle
The three key elements of the cash conversion cycle are:
- Days inventory on-hand: The current inventory level and how long it takes the company to sell it. Poor inventory turnover could signify redundant inventory, poor inventory management or poor sales performance.
- Days receivables outstanding: The time taken to collect cash from customers. The quicker cash is collected, the faster it can be deployed in the business. High days can indicate poor management of credit processes and cash collection procedures.
- Days payable outstanding: The time taken for a company to pay suppliers for purchases. The lower the number, the faster the company is paying suppliers. The higher the ratio, the better payment terms the company enjoys.
The ideal CCC scenario is for the company to minimize days inventory on hand and days receivables outstanding, while delaying payments to suppliers as long as possible, of course without damaging the relationships with suppliers. When this is achieved the working capital available to the operation can be significantly more than a simple profit/loss calculation might suggest.
The cash conversion cycle in context
A comparison of three major Canadian retailers—Loblaws, Metro, and Empire—illustrates just how important context is to mastering the CCC. Loblaws has much longer days inventory on-hand and receivables than its rivals (factors which may well be impacted by other Loblaws business lines, operating outside the retail environment). However, the company’s days payable outstanding is significantly longer than either Metro or Empire. This allows Loblaws to maximize its available cash, even while it faces inventory and receivables challenges that don’t apply to its competitors.
Clearly, companies of the size of Loblaws can use their scale and influence across the supply chain to negotiate favourable payment terms with suppliers. Nonetheless, even large players need to think carefully to avoid CCC decisions unexpectedly impacting their operational ecosystem. If one company thoughtlessly adheres to a short days payable ratio, this can effectively create room for others to maximize their days payable. Conversely, however, when all parties push the days payable limits, the ecosystem can stretch to breaking point, and when this happens there aren’t likely to be any winners.
For example, many smaller Tier 2 and 3 Canadian automotive suppliers went bankrupt around 2008 as the OEMs and Tier 1s looked to them as sources of financing during the credit crunch. Many of them failed, leading to challenges as the automotive business came back in the following decade.
Context, as always, is key.
Thinking beyond cash
While more cash on hand is by definition a good thing, there are specific situations where enhanced liquidity can be particularly useful. Reducing the CCC can free up the resources to drive a product launch, for example. Here the company can utilize cash to achieve a strategic objective without taking on debt. This is an attractive prospect, for obvious reasons.
A focus on reducing the CCC can also do more than simply free up cash. In some instances, adopting this alternate lens on the business can spark new ways of collecting and analyzing data. Often, a strong CCC focus allows otherwise hidden operational flaws and inefficiencies to be exposed, understood, and dealt with.
Again, caution is the watchword. Simply extending days payable outstanding can improve the performance of working capital and reduce the CCC, but this improvement might still mask poor operational performance. Taking longer to pay suppliers, in other words, is no panacea for the poor management of inventory and receivables. A thorough approach to reducing the CCC should focus on all three areas equally, rather than gunning straight for days payable.
Cash conversion cycle as an investment tool
The CCC lens can also be a handy tool for investors and analysts. According to a 2012 article from Forbes, the best stock returns over the five year period leading up to 2012 were delivered by players that managed their working capital most efficiently: “The next time you decide to get exposure in the retail space be sure to check the CCC,” says Forbes. “If the cash conversion cycle is broken, the retailer might be too.”
A thorough and balanced approach delivers results
Companies should start by including the CCC as a key performance indicator, monitoring it and its components regularly over time and then they can start managing towards improvement. Benchmarking against competitors or industry standards is also a useful exercise and can help highlight opportunities for improvement.
The CCC is accelerated when a company can minimize days inventory on hand and days receivables outstanding, while postponing payments to suppliers for as long as possible. A thorough and balanced approach to reducing the CCC should focus on all three areas equally. Achieving results will require a collaborative approach across functions by engaging people and improving processes. For example: sales, involved with managing receivables; purchasing, optimizing the payables, and; operations, examining inventory with the CFO or the CEO. Together, these efforts drive the overall objective of freeing up cash to invest in the business.
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Adam W. Silver is the Managing Director of the Performance Acceleration practice at Farber. The Performance Acceleration practice helps executives and boards overcome operational and strategic challenges to uncover potential and unleash performance. Adam can be reached at 416.496.3734 and email@example.com.