According to a recent study by the SBA, of the top eight reasons small businesses fail, six have to do with the inability to properly manage company funds. This includes capital used to start the business and taking care of cash once sales start to come in. As the oft-cited saying goes, cash is king and is an extremely important component of running a business. Calculating a business’s cash conversion cycle is a solid way to investigate whether it is properly managing its cash flows.
Calculating the Cash Conversion Cycle
The cash conversion cycle measures how efficiently a company manages its cash outlays and the cash it receives. Specifically, the conversion cycle is measured in days and calculated by adding days in inventory and days in receivables, then subtracting out days payables outstanding. A website search will quickly lead you to the formulas and walk you through the complete calculation, but below is a brief summary of the three key categories.
Days in inventory = 365/(COGS/Ave. Inventory)
Days in receivables = 365/(Sales/Ave A/R)
Days Payables outstanding = 365/(COGS/Ave. A/P)
A Retail Example
The lower the cash conversion cycle, the better. In the big-box retailing industry low-cost giant Wal-Mart boasts a low conversion cycle of about 9.3 days, which consists of 41.7 days in inventory, 3.1 days in receivables, and 35.5 days payables outstanding. Rival Target has a much higher conversion cycle at a little over 50 days while Sears is even worse at more than 76 days. Not surprisingly, the strongest player has the best conversion cycle. Overall, a firm is in the best shape when it turns its inventory over often (which stems from sales), gets paid quickly by customers (turns receivables into cash), and takes a while to pay suppliers and other payables, within reason of course.
An interesting exercise might be to calculate the cash conversion cycle for your business and compare it to the industry average, a publicly-traded player or other archrival. These statistics can usually be found in a trade publication or trip to your local library and could prove especially insightful, especially if it helps illuminate ways to better manage cash as it moves in and out of your business. It will also be important to track the cycle over time to see if the trends are improving or deteriorating.