State and local restrictions continue to put an unprecedented amount of pressure on businesses. Some companies have already shut down while others are struggling to keep the lights on (unless a certain power company pulls the plug, but that’s a different story). All this pressure puts a spotlight on how quickly your company is generating and collecting cash.
The Operating Cycle
The first important financial metric is called the Operating Cycle. This is particularly useful for companies that sell products (rather than services). This measures the number of days a company makes one complete operating cycle, i.e. the process of purchasing merchandise, selling it and collecting the payment due. A shorter operating cycle means that a company generates sales and collects cash faster.
Calculating the Operating Cycle is done by adding two financial ratios together: Days Inventory Outstanding (also known as “inventory turnover in days”) and Days Sales Outstanding (also known as “receivables turnover in days” and “collection period”).
How does this help the business owner? The best application of the Operating Cycle is to calculate the results either every month or quarter. These results should then be charted to visually track your performance. If the performance is deteriorating (i.e. is taking longer) then you should investigate both your inventory levels and how long it is taking to collect payment.
The Cash Conversion Cycle
The second important financial metric is called the Cash Conversion Cycle. This measures how quickly a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and then collects the amount due. Generally, like the Operating Cycle, the shorter the Cash Conversion Cycle the better.
The Cash Conversion Cycle is made up of three components: Days Inventory Outstanding plus Days Sales Outstanding (the Operating Cycle) less Days Payable Outstanding (“DPO”). DPO is also known as accounts payable in days or the payment period. Generally we like to see a longer DPO than a shorter one.
What Does It Mean?
Again, the business owner should track these measures either monthly or quarterly. Is your business performing better or worse over time? It is important to measure the impact of each component.
Inventory turnover: If it’s too low, do you have too much inventory or are carrying too many products? Are there ways you can optimize your inventory with better ordering practices?
Days Sales Outstanding: If it’s high, are you giving your customers too much time to pay their invoices? Would offering a discount for prompt payment assist your business cashflow?
Days Payable Outstanding: If it’s low, what are the terms of your payments with your suppliers? Is your payment due date too soon and can you renegotiate your terms? Or are you paying too quickly and can you stretch this out without disrupting your vendor relationships?
Understanding your working capital requirements through the Operating Cycle and the Cash Conversion Cycle are critical to navigating adverse business environments. Companies that improve their liquidity by adopting efficient working capital management strategies will be able to emerge from this crisis in a stronger position.
Kevin Lowther, AM, ABV, FMVA, is a partner with Bakersfield-based Central Pacific Valuation. He provides business valuation and financial analytics services.