It looks like we may be close to the turning point when interest rates will rise and capital availability tightens due to our recovering economy and, of course, the effects of the upcoming midterm elections.
For private, middle-market companies, the main traditional sources of growth capital have been internal capital generation from profits, family and friends, and bank lines of credit. But there are other ways to finance the growth of your business, interest free and without borrowing money.
The most successful businesses in the U.S. utilize OPM (Other People’s Money), primarily from suppliers and customers, to maximize cash flow and avoid incurring debt to finance business operations. Two terms that these companies are very familiar with and that you need to know are “Cash Conversion Cycle” and “Corporate Trade Credits.”
The Cash Conversion Cycle
The Cash Conversion Cycle (CCC) measures how long a company will be without cash because it has spent cash (for example, on inventory) in order to expand customer sales. It is essentially a measure of the liquidity risk created by growth and the expense of cash as a result of the growth of the business. Many companies often wonder why their business is growing but they are always short of cash — the CCC is the reason.
When companies take an extended period of time to collect outstanding bills, or when they overproduce inventory, the CCC measured in days lengthens. More inventories purchased means less cash available. For small businesses without large credit lines, a long CCC can mean the difference between success or failure as the business has to pay debts to vendors for inventory or services faster than it is receiving cash from its customers.
The CCC calculates the time it takes to convert inventory into cash. It is composed of three categories: days sales outstanding, days payable outstanding, and days inventory outstanding. Days sales outstanding is the amount of time a company takes, on average, to collect bills. Days payable outstanding is a firm’s average period of time to pay bills. Days inventory outstanding is the amount of time, on average, a firm takes to convert inventory to sales.
To calculate the CCC of your company, add days inventory outstanding (DIO) to days sales outstanding (DSO), then subtract days payable outstanding. The lower the number, the more efficient the business.
Credit payment terms for each customer should be based on CCC reports by customer as well as the CCC measured at the entity level. Trade discounts can be given to slower paying customers while “better” customers may receive no discount for early payment. Seems like a contradiction to offer slow paying customers a “deal” but it is an effective way to accelerate cash collections.
Some companies even achieve negative days by shipping directly from the supplier to the customer, arranging terms where the supplier provides credit but the customer pays in cash, or turning over inventory so quickly that it is sold before the seller has to pay for it. Best Buy, a leading retailer of technology products, achieved an significant negative CCC when HD TVs were flying off the shelves in the early days of their introduction.
Using Corporate Trade Credits
The second term relevant to financing your business is Corporate Trade Credit (CTC). CTC is the largest use of capital for a majority of business-to-business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses. Walmart, the largest retailer in the world, has used trade credits as a larger source of capital than bank borrowings; trade credit for Walmart is eight times the amount of capital invested by shareholders. Closely linked to CCC, CTCs are arranged at the time of negotiating with a vendor or new supplier while CCC is generally viewed as the ongoing management of the company’s cash flow. Trade credits facilitate the purchase and sale of goods without the immediate transfer of cash. Payment terms, form of payment, and credit limits are all subject to negotiation.
If you are unfamiliar with the terms CCC and CTC, you and your CFO should do some research on best practices in your industry. And it never hurts to ask your vendors about the best CTC that they can give to you because they are probably doing the same with their own suppliers.