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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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EOS is just that, an Operating System

by Marc Borrelli | Jun 5, 2021

The EOS Model® provides a useful foundation for businesses, but it falls short in addressing key aspects of creating an growth. By incorporating additional elements from the Gravitas 7 Attributes of Agile Growth® model, businesses can create a more comprehensive system that promotes growth while maintaining smooth operations. Focusing on Leadership, Strategy, Execution, Customer, Profit, Systems, and Talent, the 7 Attributes of Agile Growth® offer a more encompassing approach to achieving success.

What has COVID done to Company Culture?

by Marc Borrelli | May 30, 2021

COVID has affected everyone. However, companies need to examine if they have lived their core values during COVID, how they are reinforcing them in a WFH environment, and especially with the onboarding of new hires.

Profit ≠ Cash Flow

by Marc Borrelli | May 23, 2021

Knowing how much cash you generate is essential for planning for growth. Too many companies don’t know and when they grow they find they are continually running out of cash. Understand your cash flow generation and how to improve it through improvements in your Cash Conversion Cycle and using the Power of One.

What Are Your Critical and Counter Critical Numbers?

by Marc Borrelli | May 16, 2021

The key to achieving long term goals is to define short term goals that lead you there. Focusing those short term goals around a key metric is essential. However, ensure that the metric will not lead other areas astray by having an appropriate counter critical metric act as a counter balance.

Rethinking ‘Family’ Culture in Business: Fostering Performance and Success

by Marc Borrelli | May 8, 2021

Explore the importance of company culture and the potential pitfalls of adopting a “Family” culture in organizations. Learn how to foster a high-performance culture while maintaining key family values and discover success factors for family businesses. Rethink the “Family” culture concept and create a thriving environment for your organization.

Do You Truly Know Your Core Customer?

by Marc Borrelli | May 1, 2021

Knowing the profit of your core customers is key to building a growth model. Many companies have identified core customers that are generating a sub-optimal profit and so they cannot realize the profits they seek. Identifying the correct core customer allows you to generate profits and often operate in “Blue Ocean.”

The Spectacular Rise and Fall of the European Super League

by Marc Borrelli | Apr 25, 2021

The European Super League (ESL) collapsed within 48 hours of its announcement due to hubris, a lack of value creation, and fan backlash. The founders’ arrogance led them to disregard European football’s deep-rooted traditions and culture. At the same time, the focus on wealthy club owners instead of merit undermined the essence of the competition. The fierce backlash from fans, who felt betrayed by their clubs, demonstrated the importance of prioritizing supporters’ interests in football.

When Should I Sell My Business?

by Marc Borrelli | Apr 23, 2021

Many business owners want to sell at the top of the market. However, market timing is tough. Is this the best strategy? Probably not.

Does Your Financial Model Drive Growth?

by Marc Borrelli | Apr 18, 2021

Working with many companies looking to grow, I am always surprised how many have not built a financial model that drives growth. I have mentioned before a financial model that drives growth? Here I am basing on Jim Collin's Profit/X, which he laid out in Good to...

COVID = Caught Inside

by Marc Borrelli | Apr 10, 2021

As we emerge from COVID, the current employment environment makes me think of a surfing concept: “Being Caught Inside When a Big Set Comes Through.” Basically, the phrase refers to when you paddle like crazy to escape the crash of one wave, only to find that the next wave in the set is even bigger—and you’re exhausted. 2020 was the first wave, leaving us tired and low. But looking forward, there are major challenges looming on the horizon as business picks up in 2021. You are already asking a lot of your employees, who are working flat out and dealing with stress until you are able to hire more. But everyone is looking for employees right now, and hiring and retention for your organization is growing more difficult.

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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.