Understanding and Optimizing Your Cash Conversion Cycle

by | Financial Improvement | 2,524 comments

Many companies struggle with understanding their Cash Conversion Cycle and how it impacts their growth. The Cash Conversion Cycle is the time taken from when you first engage with a potential client to being paid for the work you do or the product you deliver. Companies need cash to fund growth, and profit is not the same as cash flow. A longer Cash Conversion Cycle requires more cash for growth and external sources, which may not always be available at economically viable rates.

Components of the Cash Conversion Cycle

The Cash Conversion Cycle can be broken down into four components: Sales Cycle, Make/Production & Inventory Cycle, Delivery Cycle, and Billing and Payments Cycle. Each component varies in duration for different companies and industries. For example, Company X might have a 120-day Cash Conversion Cycle comprising 40 days for Sales, 30 days for Make/Production and Inventory, 5 days for Delivery, and 45 days for Billing and Payments. The challenge is to reduce the length of the cycle.

Three Ways to Improve the Cash Conversion Cycle

  1. Eliminate Mistakes: The easiest way to improve your Cash Conversion Cycle is by identifying and rectifying mistakes that lead to delays in each component of the cycle. Work with your team to pinpoint the most significant errors and implement a program to reduce them. Measure your cycles and errors to minimize delays in your Cash Conversion Cycle.
  2. Shorten Cycle Times: Investigate cycle times and underlying processes for improvement opportunities. This step is slightly more complex, as it requires reevaluating your existing processes and asking deeper questions. Tom Wujec’s “How to Make Toast” exercise can help visualize the process, break it down into manageable steps, and identify areas of improvement. See below.
  3. Improve Business Model: The final method to enhance your Cash Conversion Cycle involves refining your business model. Look for ways to optimize each component of the cycle by eliminating inefficiencies and streamlining processes.

Understanding and optimizing your Cash Conversion Cycle is crucial for business growth. By focusing on eliminating mistakes, shortening cycle times, and improving your business model, you can reduce the time it takes to convert your efforts into cash and, ultimately, fuel your company’s growth.

Asking the Right Questions: Challenging the Status Quo

Another way to improve cycle times is by questioning the existing method and exploring alternative approaches. This process can be challenging due to built-in biases but can lead to significant improvements with the help of a skilled facilitator.

Using the 5 Whys Technique

The 5 Whys technique is powerful in identifying the root cause of problems, understanding process relationships, and eliminating assumptions or biases. This method is highly effective without the need for complicated evaluation techniques.

Improving the Business Model: A Challenging but Rewarding Approach

The most challenging but potentially most rewarding method to improve the Cash Conversion Cycle is reevaluating and adjusting your business model. A famous example of this approach is Dell Computers, which dramatically improved its cycle by adopting a build-to-order model. This section will further explain how Dell achieved a reduction in its Cash Conversion Cycle through strategic changes in its business model.

Dell’s Transformation: The Build-to-Order Model

Dell Computers decided to manufacture computers only when customers placed orders. Doing so shifted their business model from a traditional inventory-based approach to a customer-centric, build-to-order model. This change led to significant improvements in each component of their Cash Conversion Cycle, as outlined below:

  1. Sales Cycle: As customers customized their computers during the ordering process, Dell was able to streamline its sales cycle. The company no longer needed to carry a wide range of pre-built computers, enabling them to better target their marketing and sales efforts.

  2. Make/Production & Inventory Cycle: Dell’s build-to-order model significantly reduced the need for finished inventory. They only had to maintain a minimal level of inventory for components required for custom orders. This approach also reduced the risk of obsolete inventory, as Dell only purchased components in response to specific orders.

  3. Delivery Cycle: By having customers pay for their computers when placing orders, the delivery cycle’s impact on the Cash Conversion Cycle became less significant. Dell could focus on efficient production and timely delivery without worrying about the cash tied up in finished goods.

  4. Billing and Payments Cycle: With customers paying upfront for their orders, Dell eliminated the need for a lengthy billing and payments cycle. The company received cash from sales before starting production, freeing up working capital and reducing the time it took to collect payment.

The Result: A Negative Cash Conversion Cycle

As a result of these strategic changes in their business model, Dell reduced its Cash Conversion Cycle from 63 days to an impressive -39 days. This negative cycle meant that Dell effectively used its customers’ cash to fund its growth, eliminating the need for external financing and improving overall cash flow.

Dell’s success story exemplifies the potential benefits of rethinking your business model to improve the Cash Conversion Cycle. By identifying areas of inefficiency in your current model and exploring innovative alternatives, you can significantly reduce your reliance on external financing sources and drive sustainable growth.

However, it’s essential to keep in mind that the right approach for your business may differ from that of Dell or others. The key is to analyze your unique situation, understand the challenges specific to your industry, and find innovative solutions that best align with your company’s goals and resources.

Are You Optimizing Your Cash Conversion Cycle?

Understanding and optimizing your Cash Conversion Cycle can reduce your reliance on bank lines of credit and other debt sources. If you need help determining your cycle and shortening it, consider reaching out to a professional for guidance.

Copyright (c) 2021, Marc A Borrelli

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  1. Mark McKenzie
    Mark McKenzie on September 2, 2021 at 2:23 pm

    Marc, Thanks for sharing this. Especially as Cash on hand is so important for any business.

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