The Cash Conversion Cycle (CCC) is the most important key performance indicator for your company’s working capital management and funding. Let’s discuss what it means.
Your company pays dividends to your shareholders for giving equity capital, if you are an incorporated company. Short-term and long-term debt cause interest expenses to lenders. Overall you can derive the Weighted Average Cost of Capital (WACC) for your company.
You are going to be anxious to lower your cost of capital by reducing the amount you have to pay to your stakeholders. Easiest way doing so, is to lower your cash, which is part of current assets, and pay back short-term debt, which is part of current liabilities. Result is a lower interest position in your company’s income statement that will lead to higher income, increase returned earnings, and in return increase cash again.
But, you will do this only if the Internal Rate of Return (IRR) of the lower tail of your projects is lower than your cost of capital. Projects with higher returns than the WACC are profitable, and therefore need to be funded.
What can you do to maximize your company’s cash with existing funds? One way of doing it is to minimize your Cash Conversion Cycle by minimizing your Days Sales Outstanding (DSO) and Days Sales Inventories (DSI), as well as maximizing your Days Payable Outstanding.
CCC↓ = DSO↓ + DSI↓ – DPO↑ => min
All of these measures are calculated in average number of days the relevant process takes to be finished. In other words, you ensure that you drive your Order-to-Cash and Procure-to-Pay process at the optimal edge, and eliminate inefficiencies.
How can we explain this flow in our balance sheet?
Let’s start at the right-hand side of the above picture. The so called passive side of the balance sheet gives an overview of where the money comes from. This is either equity, which is driven by capital we received from shareholders, and retained profits (earnings) our company generates. Or, it is liabilities. These are grouped in current (less than one year), and non-current (anything above one year). If we want to influence the Cash Conversion Cycle, we target current liabilities. Accounts payable amounts to our suppliers are linked to this group. The terms of payment (or payment terms) that we negotiate with them is a low cost financing if it doesn’t effect the price of the goods and services that we receive. If we can use our power to extend these payment terms and increase Days Payable Outstanding, then we need less funding from other lenders like banks.
On the balance sheet, equity and liabilities together must be the same amount like the total of all assets. In other words, we know the sum of the left side of the balance sheet already. The left side is also called active side and tells us, what the money is used for. Similar to liabilities it is grouped in current and non-current. Non-current assets are fixed assets like plants and equipment, or intangible assets like patents. For the discussion of our Cash Conversion Cycle, it is not our focus.
Our focus is on current assets. So, remember that we focus on current assets and liabilities only, because we can influence cash into our pocket short term. No wonder that cash is part of current assets too. What we need to do is to ensure that inventories and accounts receivables are getting cashed-in as fast as possible. Free cash is then used for paying back debt if we have no projects that have an Internal Rate of Return above the Weighted Average Cost of Capital.
Days Sales Inventories are minimized by having only raw materials, semi-finished, and finished goods on stock that are just required to deliver and sell in time. Slow movers need to be eliminated. Large stocks of raw materials make sense only, if the lower price that we can negotiate from an rebate agreement leads to lower total cost including financing cost.
Days Sales Outstanding need to be minimized by an effective credit management department. This includes risk factors as well. The article “Mitigate your risk of open accounts receivables and influence your interest rate” speaks in detail about this topic. Key message is to minimize your past due amounts and negotiate short payment terms, or at least not above country and industry standard. Cash discounts should be granted only, if they make financial sense. Keep in mind that granting a 2% cash discount for receiving the payment 2 weeks earlier, is similar to an annual effective interest rate of more than 50%. If you want to catch the deal, commercial team should setup an attractive subsequent compensation agreement with several quantity layers (rebate).
Emerald Rating is an award-winning FinTech company providing comprehensive financial knowledge. We can help you to setup a Best Practice Credit Management Process and minimize your Cash Conversion Cycle.
Author: Danny Kaltenborn, Date: February 4, 2020