Cash is king in a new and growing business. The faster cash comes in after your work, product or invoice goes out (your cash conversion cycles), the better. But short cash cycles alone don’t grow your business. For one, they don’t deliver the fundamentals of profitability or good unit economics.
In Part I, we talked about when cash cycles might not be the source of your cash flow problem. I gave you a great book to read to fix your bottlenecks, and we discussed the first method of looking at cash conversion: the four cash cycles. In this article, we will go through the second, quicker method and what to look at to fix those cash conversion cycles. (Also check out my other articles on that topic.)
Method Two: The Simple Method of DSO + DSI – DPO
The other method I talk to a number of entrepreneurs about is a simpler calculation. It’s based on the day’s sales outstanding (DSO). How many average days between the sale of a product and the receipt of cash? You can Google the formula for that, but it’s fairly simple. It’s a calculation between your average, normal A/R balance and your net sales.
If you look at all how customers pay you, this method intends to give you an answer. Say if customers pay you in 45 days, your DSO is 45. Then you have day sales and inventory. How much inventory do you have based on your relative revenue? If you have $400K in inventory and $100K in COGS every month, and we have four months, or 120 days, of inventory on hand. Now you’re saying, I got 120 days in day sales in inventory (DSI).
Now subtract the days payable outstanding (DPO), which is the inverse of the A/R figure. This figure is saying how much do I owe people relative to my COGS? What are my terms of my manufacturing, or to my suppliers? In a sense, your payables represent them financing you instead of you financing the customer on A/R.
This cash conversion cycle method looks at DSO plus DSI minus the DPO. That calculation gives you a relative sense of where you can create impact by moving those numbers. You can say, if I took the 18 and moved it to 30 and I moved DSI from 120 to 90, where is the impact? Where is the low-hanging fruit in that equation? Some people can focus on overall goals, saying, “Let’s get that down and set a target.” It’s a simpler way of looking at it.
For example, in a services-based business like a law firm, we tend to see long A/R aging. The firm is highly profitable because they’re charging a large hourly rate to cost. So the cost of holding that cash in Accounts Receivable is much less of a concern. Their opportunity cost, if they call their customers who aren’t paying, is to bill time to another customer. Smaller law firms commonly ignore their A/R because the incentive is to keep working and billing. With a lack of discipline, the culture can slide into higher A/R balances, which can have a negative long-term effect if they keep accruing.
What we did for a company like this was to help create visibility around A/R aging. If Jim’s DSO is 72, but Frank’s is 43, it brings visibility to Jim’s lack of focus on his collections, and his effects on the firm’s cash and how it can grow. Bringing that to light can be super helpful in some situations. That’s where the simple method comes in.
Fix What You Find
Replay: Look at Yes-to-Delivery Cycle
Let’s jump back to the sales cycle. To me this is not about a sales rep in the field telling customers, “Hurry up and make a decision because they need to reduce my sales cycle and get this product going.” That’s not likely the bottleneck. While there may be lollygagging in terms of moving the customer along effectively, that’s not the purpose.
When you get to that “yes” point with the customer, the issue becomes: how long until delivery or a service is provided?
So much can go wrong here. You might need to get contact information, or determine final pricing, or get pricing approval. Some larger companies will stop the process, saying “we didn’t authorize that pricing” or “let’s figure out who gets commission for this sale before we deliver.” Logistics may need to be coordinated. “They’re ready to sign but we don’t know the install date.” Or, “They said yes, but we don’t know when they can accept delivery or when we’re going to implement.”
As a remedy, your company can get in there and say, “Hey, I know you’re still thinking whether this is a yes or no. In parallel, I’d like to send our contract to your attorney so we can sign as soon as you are ready to go. Is that okay with you?”
Same with logistics and coordination. Things can get wrapped around the axle there, even just setting up the customer in your system, getting their tax ID, addresses and all contact info before you deliver. Or the customer is on vacation for a week and this delays the whole process. Of course, if you’re the finance guy or the CEO, you’re thinking, “Just send them the goddamn product—why is this slowing it down?”
As organizations grow, the original process that worked on a smaller scale can get clunky and break down. Unwinding these cycles can help see where this is happening. Then you can fix it. On the delivery side, companies do seem to be getting better about their cash cycles. Many in CPG or consumer packaged goods are using 3PLs to do a lot of stuff.
Second, what’s causing it? After you know what that cycle is, from the time you can say “go” to the time the customer gets delivery and you can recognize revenue… you can ask: what’s causing problems in there? Is that period too long? Should it be lower? Is it out-of-stock issues? Is it supplier reliability issues? Are we not forecasting correctly? Do we just have the wrong parts in stock?
We talked earlier about these parallel processes—could you begin assembling the implementation team prior to the deal being won, in terms of scheduling implementation and delivery in advance? Many things can be done there to help.
I think on the billing collect cycle, we talked a little about the positives. We talked about building discipline in the law firm. A number of things can be done there, like payment terms. You can set up ACH to connect to the customer if it’s a repeat buy; that can facilitate getting that cash in the door.
But again, if you’re trying to move your cash collection from 40 to 30, be careful of the asymptotic curve, or diminishing returns in terms of the effort required to achieve the next level. For example, it’s easier to raise your grade from a C- to a B+ than from a B+ to an A. If you’re trying to go from 40 days DSO to 25, there’s an increasing cost of perfection, an increasing of cost of getting that down. Is the juice worth the squeeze?
That’s the biggest thing to keep an eye on when focusing on the cash conversion cycle, because you might discover you are either: a) NOT going after the low-hanging fruit, or b) it’s not the core problem of the business at all. It’s still an opportunity, but it’s not the number one opportunity.
Knowing where cash conversion should fall in your priority stack is the business acumen that comes into play here.
RELATED: Part 1