The Cashflow Gap (Part 3): How retailers and wholesalers can measure cashflow

So how do retail business owners go about measuring this cashflow? The cash conversion cycle is one of the most important metrics in this department, demonstrating to business owners just how effective their processes and procedures are in terms of generating profit, managing expenses, and operating with efficiency.

On balance, it is better to have a shorter cash conversion cycle than a longer one, as this is representative of a company with a good level of liquidity. However, the implications of a cash conversion cycle actually go far beyond this.

What Exactly is Cashflow Conversion Cycle?

In simple terms, the cash conversion cycle - or CCC - is the length of time, measured in days, taken for a company to convert the investments and assets in its inventory into cash generated from sales. There may be other resources which are also factored into this calculations, but, for most businesses, the bulk of this cashflow will be coming from stocked products in inventory. And this is important - as a business owner, you invest in products because you want them to sell and generate profit for your organisation; understanding how quickly this is achieved is vital.

So, the quicker you can convert invested cash into end returns and profits - i.e. the lower the ratio of the CCC - the better.

Calculating Cash Flow Conversion

Calculating the CCC means considering three distinct stages of the cashflow conversion process.

Firstly, the existing inventory level is taken into account, and we consider how long it will take for a business to sell off its inventory. This is represented in the calculation as Days Inventory

Outstanding - or DIO.

DIO = (Average inventory / COGS)*365 days

Secondly, the calculation examines the current sales and the time taken to collect cash generated from these sales. This is the Days Sales Outstanding figure - or DSO.

DSO = (Average Accounts Receivables / Revenue)*365 days

Thirdly, the calculation focuses on the current outstanding payables relating to the business. This usually relates to money owed from the company to its suppliers for the current inventory. In terms of the calculation, the figure is the time period, in days, for the company to pay off this debt, and is represented as Days Payable Outstanding.

DPO = (Average Accounts Payable / COGS)*365 days

To complete the calculation, we use the following formula;

Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) - Days Payables Outstanding (DPO)

or;

CCC = DIO + DSO - DPO

Getting these three smaller calculations right is vital, however, and these must be completed before the cash conversion cycle can be gauged.

Why the cash conversion cycle matters

What is it that makes the cash conversion cycle such an important metric for your business? There are actually two key factors here. The first is that CCC is a clear indicator of efficiency in handling and managing working capital assets, particularly critical assets such as inventory. The second is that CCC offers a viewpoint from which to gauge liability management; i.e., how effectively is a company able to pay off its current liabilities.

Most contemporary financial reporting focuses on quick and current ratios, designed to measure how quickly an organisation can sell its inventory to make way for more stock. However, the CCC takes things a step further, measuring how quickly the company can turn this inventory into sales and then turn these sales into receivable cash, making this ratio a far better demonstration of company liquidity.

The CCC also helps us to identify where cashflow issues are coming from. The longer the inventory remains unsold, the longer it takes to collect the accounts receivables. When we factor in a shorter payment window for debts to company suppliers, we can deduce that cash is being tied up in inventory, and available cash is being quickly depleted as trade payables are managed. Over time, this trend will squeeze the available cash a company can draw upon, greatly reducing liquidity.

This is why the CCC's individual components are so critical to business. Business owners can use these smaller calculations to spot positive and negative trends in the way in which their company manages its working capital. When the CCC ratio is lower, there is less need to borrow additional capital, and more opportunity to achieve pricing discounts through direct cash purchases on materials. There is also an increased capacity for growth and expansion. This is what we should be working towards.

The CCC in action

Let's look at how CCC works. As an example, John is a wholesaler selling bathroom accessories to large residential developments. John purchases his inventory from one main vendor and pays off the outstanding balance on accounts within 30 days to achieve a discount. The inventory turnover rate of John is 4 times a year, and he collects accounts receivable from large property developers generally within 45 days on average.

This translates to;

Days Inventory Outstanding (DIO) - 90 days

Days Sales Outstanding (DSO) - 45 days

Days Payables Outstanding (DPO) - 30 days

DIO + DSO - DPO = 105 {compare to average SME at 84 days} So, John’s cash conversion cycle is 105days. In other words, it takes one hundred and five days to get from paying for inventory to receiving the cash from the sale.

PWC’s working capital study highlights how the CCC is strongly favorable for large organisations compared to smaller businesses. This is driven by things such as better processes, superior systems and most importantly positive payment terms leveraged by simply being large. According to the PWC report the average CCC for large enterprises is 37 days (just over a month) compared to 64 days for a mid-tier enterprise and a staggering 84 days (nearly a quarter of a year) for small business. A significant difference.

Based on the above, at a minimum, John can look to improve his current CCC from 105 days to a minimum of 84 days (as suggested by PWC). This can be achieved by focusing on supply chain management to reduce inventory levels, debtor collection (offer discounts for 7-day payment or offer online settlements) and negotiating better payment terms.

Over the course of this series, we've really got to grips with some of the cashflow issues affecting Australian retailers and wholesalers. We've analysed some of the factors which are harming cashflow, and how alternative finance can provide a solution. We've also looked at how better inventory management can reduce the strain caused by cashflow, and outlined some of the calculations and metrics you can use to monitor cashflow in your business.

Together, these elements help you to create a robust defence against what is potentially a catastrophic issue. Measure your cashflow, manage and mitigate the factors which impede it, and secure high levels of efficiency and efficacy for your organisation.