cash conversion cycle Archives

Understanding and Optimizing Your Cash Conversion Cycle

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

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.
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.
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:

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.
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.
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.
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.

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The Downfall of Boeing: A Lesson in Core Values

by Marc Borrelli | Apr 27, 2022

Boeing’s 737 Max issues highlighted the company’s sacrifice of safety for financial performance, resulting in a tarnished reputation. The prioritization of profit over core values also damaged the FAA’s credibility and revealed a lack of accountability for top executives. This downfall serves as a reminder of the importance of maintaining core values and prioritizing them over short-term financial gains.

Resolutions, Here We Go Again.

by Marc Borrelli | Jan 16, 2022

In reflecting on 2021 resolutions, the author scored themselves in three categories and sought to improve success in 2022 by addressing friction points. Drawing on advice from social psychologist Wendy Wood, the author identified areas to reduce or increase friction in their failed resolutions. By making these adjustments, the author aims to enhance their goal achievement and encourages others to consider friction when setting resolutions.

You need to take an extended vacation. No, seriously, you do.

by Marc Borrelli | Sep 27, 2021

COVID has taken a toll on all of us. If you have not taken an extended vacation in a while where you disconnect, you need to now. You and your business will benefit.

Becoming Famous in Your Niche: The Success Story of Linn Products Limited

by Marc Borrelli | Sep 5, 2021

In a previous discussion, I highlighted the importance of being famous for something. Being well-known in your niche can help you: Concentrate on your strengths Connect with your target audience Communicate your offerings more effectively Receive referrals Identify...

Understanding and Optimizing Your Cash Conversion Cycle

by Marc Borrelli | Aug 29, 2021

Understanding and optimizing the Cash Conversion Cycle is crucial for business growth, as it impacts cash flow and the ability to access external capital. This cycle consists of four components: Sales, Make/Production & Inventory, Delivery, and Billing and Payments. To improve the Cash Conversion Cycle, companies can eliminate mistakes, shorten cycle times, and revamp their business models.

Discovering Your Niche: Why You Need to Be Famous for Something

by Marc Borrelli | Aug 22, 2021

As an entrepreneur, it’s crucial to specialize in a specific area and become famous for something, allowing you to generate referrals and build your brand. Understanding the “job” you’re hired for helps you stand out in the marketplace and communicate your value proposition effectively. By providing value to your clients, you can adopt a value-based pricing approach, ensuring your business remains competitive and maintains a strong market presence.

Rethinking Your Pricing Model: Maximizing Margins and Providing Value

by Marc Borrelli | Aug 15, 2021

Rethink your pricing model by focusing on the value you provide and your customers’ Best Alternative To a Negotiated Agreement (BATNA). This approach can help you maximize margins while delivering better value to your clients. Assess your offerings and brainstorm with your team to identify pricing adjustment opportunities or eliminate commodity products or services.

Do you know your Profit per X to drive dramatic growth?

by Marc Borrelli | Jul 25, 2021

I recently facilitated a workshop with several CEOs where we worked on the dramatic business growth model components. One of the questions that I had asked them beforehand was, "What is Your Profit/X?" The results showed that there this concept is not clear to many....

The War for Talent: 5 Ways to Attract the Best Employees

by Marc Borrelli | Jul 4, 2021

In today’s War for Talent, attracting the best employees requires a focus on value creation, core customer, brand promise, and value delivery. Clearly articulate your company’s mission, identify your “core employee” based on shared values, and offer more than just a salary to stand out as an employer. Utilize employee satisfaction metrics and showcase your company’s commitment to its workforce on your website to make a strong impression on potential candidates.

Are you killing your firm’s WFH productivity?

by Marc Borrelli | Jun 27, 2021

Productivity remained during WFH with COVID. However, further analysis found that hourly productivity fell and was compensated for by employees working more hours. What was the culprit – Meetings. Want to increase productivity, have fewer meetings.

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Profit ≠ Cash Flow

by Marc Borrelli

While I have known this for a long time, last week, it was brought home to me how many conflate the two. Profit and Cash Flow are not the same. I have known many profitable companies have negative cash flow and some unprofitable ones have positive cash flow. Knowing the difference is critical.

As I have mentioned before, cash is the blood in a company. Without it, the company dies, regardless of how profitable it is. Many young companies that take off don’t appreciate the issue and believe that they will solve it with growth. However, this is similar to the old business joke, “Of selling at a loss but making it up on volume.”

How the Statements Connect

For non-accountants and finance people, the issue is that they look at the Profit and Loss Statement, Balance Sheet, and Statement of Cash Flows as separate entities without realizing the interconnectedness. Finally, the way a standard statement of cash flows is laid out, most don’t know what it is saying.

It takes a while to realize that the P&L shows you the earning for the period, then the statement of cash flows shows the adjustments required to get to the cash generated from the different sources. Finally, the balance sheet is the statement at the end of the period of what is owned and what is owed. They flow in that order, generating the statement of cash flows from the profit and loss statement, and the balance sheet really cemented the relationships in my mind.

The Dates

Again, I was made aware of this when I was presented with a profit and loss statement and balance sheets, but all as of different dates. If the dates don’t sync, you can’t deduce much from them. The profit and loss statement must cover the same periods. The balance sheets must be as of the starting date and the ending date of the period. Sounds simple, but many look at these financial statements for different periods and don’t realize that you can’t tell much from them.

How to Determine Your Cash Flow

Now many people don’t understand the statement of cash flows, and I understand that. The key information is how much cash the firm generates or absorbs, what it will do with it, or how it funds the shortfall. For many entrepreneurs, here is an easy way of looking at Cash Flow. Assume your company has a Gross Margin and Net Operating Margin of 20% and a 10.15%, respectively. In addition, your Accounts Receivable, Inventory, and Accounts Payable are 80, 35.7, and 45 days respectively. If you grow revenue by $100, the effect is as follows.

Revenue	+	$100.00
Cost of Goods Sold	–	80.00
Gross Profit	=	20.00
SG&A (Overheads)	–	9.85
Net Operating Profit	=	10.15
Accounts Receivable (80 days)	–	21.92
Inventory (35.7 days)	–	9.78
Accounts Payable (45 days)	+	12.33
Cash Shortfall	=	$9.22

Thus for every additional $100 of revenue, you need $9.22 of extra cash. This is why many fast-growing companies implode, they cannot get sufficient cash to fund their growth, and without cash, the company dies. Now some will argue that I have not added back depreciation etc. That is true; however, I have found that CapEx is equal to depreciation over time if you wish your company to keep functioning, so that is just a timing issue.

How to Improve Cash Flow?

So understanding your cash flow is a vital part of understanding the financial model of your business. If you generate a shortfall, you need to figure out how you will finance it. There are really three options,

Arrange to finance for your working capital.
Shorten your Cash Conversion Cycle
Use the Power of One to change the cash generation of the business.

There are a number of companies that provide working capital financing, so if you need some names, let me know. If you don’t know your cash flow cycle, it is the time from when you start the sales cycle until you get paid. It is broken into four areas – Sales Cycle, Make/Production & Inventory Cycle, Delivery Cycle, and Billing and Payments Cycle. The Power of One, developed by Alan Mills, determines which of seven variables most influences increased cash flow.

I know many companies don’t have this information, and their accounting systems don’t know how to produce it. In that case, get a coach or adviser who can help you. The investment will be well worth the effort to understand how to drive your business without ongoing funding. If you want more information on how these work and how to implement them in your business, message me.

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Are You Prepared for 2021 With Enough Cash?

by Marc Borrelli

Well, 2020 is just about done, and as we move in 2021, are you and your business prepared? Regardless of how COVID has impacted you, the economy is slowing, so you can expect cash to get tighter as suppliers expect payment sooner and customers pay later.

With a vaccine on the horizon, companies need to be prepared to take advantage of the improving economy when we get there by weathering the current slowdown and positioning themselves for growth. As we look at the potential growth ahead with an improving economy, do you have enough cash to:

To get through the winter.
Invest in new technologies and systems to stay relevant or take market leadership.
Hire the talent you need to take market leadership or get back to where you were before COVID.
Invest in product/service development to take advantage of changes in the market due to COVID.

If your answer to 1 is negative, you are in trouble. Companies don’t go bankrupt because they lose money; rather, they run out of cash. Cash is like oxygen: if we run out of it, we die. If your answer to 1 is yes, what about 2 – 4? If you want to be in a strong market position in H2, you need to be investing now.

So, if you can’t answer 1 – 4 in the affirmative, what are you going to do? Remember, YOU CANNOT CUT YOUR WAY TO GROWTH! The easiest thing is to get bank financing. If you have a bank line or your bank will lend you the money, great! However, if not, things are a little more difficult. Please don’t take advantage of those letters, flyers you all receive offering quick financing. The interest rates are usurious and over 40% in many cases. There are other lending alternatives, and contact me if you need to discuss some.

However, what about self-funding? Have you looked at how you can generate the cash internally?

Cash Conversion Cycle

There are four basic cash conversion cycles in a company:

Sales Cycle
Production & Inventory Cycle
Delivery Cycle
Billings and Payment Cycle

Concerning your organization, do you know the length of your cycle for each of these? If you add them all together, you can define the full Cash Conversion Cycle for your company. Once you have done that, you have three questions:

What is your Cash Conversion Cycle?
Are you happy with it?
Can you improve it?
Where should you focus your efforts?

Regardless of which cycle you examine, there are basically three ways to improve it:

Eliminate mistakes

There are all sorts of mistakes that affect these cycles, from the obvious ones of production mistakes to rework, mistakes in estimates, contracts, invoices, and wrong delivery. We make them all. But do you know which ones are affecting your business the most? You need to honestly examine your business to identify where the mistakes are made and which are the largest. Focus on the biggest first as they will be the easiest to get the largest benefit from, e.g. if your inventory time is 120 days, but your billing and payments time is 30 days, it will be easier to cut five days off production than billing and payments.

Shorten the cycle time

Look at all the times and see where you can shorten them. While COVID has beaten up the “Just in Time” production process, you can still work at reducing production time and inventory time. What can you do on the sales cycle, the billings and payments cycle? Right now, everyone is at home dealing with COVID, so maybe it is a good time to work through these processes to see where efficiencies can be made. Consider working through Tom Wujec’s method of improving processes. It is a great way to see how improvements in your cycle time can be made.

Improve your business model

Changing the business model is an interesting one. Can you change how you do business so that you can dramatically alter your cash conversion cycle? Dell did and took its cash conversion cycle from 63 days to -39 days. Yes, that is -39 days. How? If you bought a computer from Dell, they are made to order, so you have paid for it before they start manufacturing. Thus, they have $0 receivables; they pay their suppliers probably 60 days and their employees 14 days. Since they are paid upfront, there is no delivery cycle, so the only other area is the sales cycle.

I once worked with a company that was facing bankruptcy and had to reorganize itself to survive. They looked at the Dell model and decided they need to copy it. They changed their business model and became the only company in their industry to have $0 accounts receivable. Using “Just in Time” production, they were paying their suppliers after they got paid. They did a great deal of market research and determined within a six-month period when their customers would purchase. Thus, they focused sales efforts on customers within that window, primarily reducing the sales cycle.

The hard part is changing the model because it is not an incremental improvement but a new model. Look at Costco, the first big-box retailer to introduce membership fees, providing a large part of its profit at the beginning of a relationship with the customer.

So, what can you do? Examine it; you will find it is well worth the effort.

Once you have examined your Cash Conversion Cycle, the next thing is to look at your business through the Power of One.

Power of One (1%)

Alan Miltz developed the Power of One and basically looks at the following financial variables and asks, “How would your cash flow improve if you increased any one of them by 1%?”

Price
Volume
Cost of Goods Sold
Accounts Receivable
Accounts Payable
Inventory
Overhead Expense

If you undertake this analysis, you will quickly see which of these variables most influence your cash flow. Starting with them from those that affect cash flow from largest to smallest, identify what percentage you would like to improve them this year and the impact on your annual cash flow and EBIT. Then work to figure out how to realize the improvement.

Working through your Cash Conversion Cycle improvements and the Power of One, it is useful to have a business coach who helps you and facilitates the meetings.

Call me to help you figure out how to improve your cash flow from now on.