This question always gets a confused response, as many don’t know their Cash Conversion Cycle or how it impacts growth. So how and why can they optimize it? Companies need cash to fund growth, and profit is not the same as cash flow. The longer the Cash Conversion Cycle, the more cash is needed for growth and external sources. In many cases, that cash may not be available at rates that make economic sense. If access to external capital is hard, growth may not be possible.
Your Cash Conversion Cycle is the amount of time taken from when you first engage with a potential client to being paid for the work you do or the product you deliver. The Cash Conversion Cycle is typically broken down into four components:
- Sales Cycle – the time taken from the initial sales contact to the order being placed or product purchased.
- Make/Production & Inventory Cycle – the time taken that you hold inventory for products and the time taken to produce the product or deliver the service.
- Delivery Cycle – the time taken to deliver the product or install it.
- Billing and Payments Cycle – the time to issue the invoice after the product or service is delivered and the time to collect payment.
If we add up in days for these various cycles, we get the Cash Conversion Cycle time. The Cash Conversion Cycle differs between companies, even those in the same industry, for multiple factors.
So if, for example, we have Company X, with a Cash Conversion Cycle of 120 days comprising the following: Sales – 40; Make/Production and & Inventory – 30, Delivery – 5; and Billing and Payments – 45, the issue is how can we reduce the length of the cycle.
There are three ways to improve the Cash Conversion Cycle in any situation:
- Eliminate mistakes
- Shorten cycle times
- Improve business model
Of the three, this is the easiest. Look at why the specific cycle takes so long and see where mistakes lead to delays. Mistakes can be as follows:
- Sales cycle – the proposal is incorrect and doesn’t meet the buyer’s needs. This part of the cycle is rarely considered.
- Make/product & inventory – there is insufficient inventory, so delivery delays. There are defects in the work, whether it be a product or service, causing delays for rework.
- Delivery time – for shipments of products, it can be mistakes in addresses or delivery methods.
- Billing and payment cycle – issuing incorrect invoices in the amount, rate, or coding causes delays.
While this is the easiest way to improve your Cash Conversion Cycle, I have found that many don’t measure it and don’t know the extent to which errors are causing problems.
It is best to work with your team to identify the errors and their effect on the cycle. Once you have identified the mistakes that cause the most significant delays, then put a program to reduce them. As John Doerr said, “Measure what matters.” You need to measure your cycles and the errors to ensure you keep the delays to your Cash Conversion Cycle to a minimum.
Shorten cycle times
The following method to improve your Cash Conversion Cycle is to investigate the cycle times and look at the underlying processes for an opportunity for improvement. Achieving this is a little more difficult as you have to step away from your existing processes and ask more complex questions.
A couple of ways to look at this are:
Got a Wicked Problem? First, tell me how you make toast. This exercise, developed by Tom Wujec, comprised three parts.
- Start with a clean sheet of paper, a felt marker, and draw how to make toast without words. Most drawings have nodes and links. Nodes represent tangible objects such as the toaster and the people, and links represent the connections between the nodes. The combination of links and nodes produces a full systems model, and it makes our private mental models visible about how we think something works. The number of nodes reflects the complexity of the model. The average illustration has between four and eight nodes. Less than four, the drawing seems trivial, but it’s easy to understand. More than 13, the picture produces a feeling of map shock. It’s too complex! So the sweet spot is between 5 and 13.
- Now with sticky notes or cards, we again ask, “How do you make toast.” You now see the step-by-step analysis that takes place, and as they build their model, they move nodes around, rearranging them like Lego blocks. This rapid iteration of expressing and then reflecting and analyzing is the only way to get clarity. It’s the essence of the design process.
- Third, draw how to make toast, but this time in a group. It starts messy and becomes more chaotic, but the best nodes become more prominent as people refine the models. With each iteration, the model becomes clearer because people build on each other’s ideas. In the end, we have a unified systems model that integrates the diversity of everyone’s points of view. These drawings can contain 20 or more nodes, but participants don’t feel map shock because they built their models themselves. If you want a better result, have the group do this in silence.
Below is a video of Tom Wujec explaining the process.
Having done this with something as simple as making toast, now apply the same methodology to your team concerning one of the cycles. New processes and improvements may be developed, reducing the cycle time.
If you were starting again, would you do it this way? Another exciting way of improving the cycle times is to ask how we should do it if we were not doing it this way already. Such a process is more challenging as the existing method has a built-in bias for the team. A good facilitator can question each step, asking the purpose of the action and whether there is another way to achieve the same goal.
One way is using the 5 Whys. The Benefits of Five Whys are:
- It helps identify the root cause of a problem.
- Understand how one process can cause a chain of problems.
- Determine the relationship between different root causes.
- Highly effective without complicated evaluation techniques.
A Gravitas client that used this methodology to improve its Cash Conversion Cycle was The Camel Soap Company. The company was based in Dubai and facing working capital issues and negative cash flow. While the sales were growing, the sales manager was struggling to keep up with the growth. Also, he was dealing with some deliveries taking him away from sales. They had substantial inventory problems (260 days) and were paying up front. Examining their Cash Conversion Cycle, they undertook the following:
- They hired a delivery driver to allow the sales manager to focus on sales.
- Installed a CRM, and revenue increased, which improved cash flow.
Make/Production & Inventory Cycle
- They introduced lean methodology.
- Looking at how many times the soap was handled during the manufacturing process shortened the cycle.
- Reduced finished inventory to 100 days from 200 days.
Billing and Payments Cycle
- Negotiated better terms from their suppliers.
Within six months, the company became cash-flow positive.
Improve business model
The most challenging method of the three, but the one that can provide the most significant benefits if done correctly. Here the objective is to look at your business model and ask how we can change it to improve our Cash Conversion Cycle.
The most famous example of improving their business model belongs to Dell Computers. When Dell decided to build a computer only when a customer ordered it, they achieved the following:
- Since each customer customized the computer they purchased when ordering; Dell reduced its sales cycle.
Make/Production & Inventory Cycle.
- This cycle was dramatically reduced as there was no finished inventory anymore. Also, because Dell built computers to order, they need less inventory as they ordered inventory against production orders.
- There was less obsolete inventory as they purchased inventory for specific orders.
- By having customers pay for the computers when ordered, the delivery cycle became irrelevant.
- As computers were paid when ordered, Dell received all the cash from the sale before starting production.
As a result of this effort, Dell reduced its Cash Conversion Cycle from 63 days to -39 days; yes, negative 39 days. Dell was using the customers’ cash to fund its growth which is a great model.
So, returning to the initial question, are you optimizing your cash conversion cycle? Do you know the lengths of the cycles of each part and how you can improve them? Improving your Cash Conversion Cycle can reduce your need for bank lines of credit and other sources of debt.
If you would like help in determining your Cash Conversion Cycle and shortening it, contact me.
Copyright (c) 2021, Marc A Borrelli
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