Steve Schlecht
April 29, 2023
In our discussions with clients, we have heard many times “I was growing and growing and growing, and then I just ran out of money.” We hear this way too often with new brands with unfavorable payment terms where investment in inventory isn’t turned into cash for sometimes weeks even up to months.
For a business that is growing and trying to strategically manage its inventory and cash on hand, the cash conversion cycle (CCC) is the critical metric to monitor. This metric measures the time it takes for a company to convert its investment in inventory to cash through sales. Understanding the cash conversion cycle and optimizing it can lead to increased profitability and growth for businesses. This article discusses the outcomes of successful uses of the cash conversion cycle and failed examples, too.
The cash conversion cycle is a critical financial metric that reflects the operational efficiency of a business. It represents the number of days between the time a business pays for its inventory and the time it receives cash from selling it. A shorter cash conversion cycle implies that the business can efficiently convert its investments into cash, which leads to better cash flow and increased profitability. It also enables the business to reinvest cash in the company, pay off outstanding debts, and grow the business.
A negative cash conversion cycle occurs when the time it takes for a business to sell its inventory and receive cash is shorter than the time it takes to pay its suppliers for the inventory. This indicates that the business can sell its inventory and collect cash before it needs to pay its suppliers for it. A negative cash conversion cycle is highly beneficial for businesses as it means they can use the cash collected from sales to pay off suppliers while keeping cash in hand. This leads to improved cash flow and lower inventory costs, enabling businesses to invest in growth opportunities.
A positive cash conversion cycle refers to a cash conversion cycle where payment for inventory or services is expensed prior to payment for the good. This metric indicates that a business pays their suppliers prior to receiving payment for their goods, which is typically the case for most companies. The higher the cash conversion cycle in days a company has, the longer it takes to realize revenue and use that money for growth, debt payments, and more.
Take a new e-commerce company that started with $20,000 in cash after purchasing 1,500 units for their product line. Their cash conversion cycle is 1 month (very long) with forecasted 5% month-to-month growth on sales, which they will maintain in inventory purchases. A two-month dip in sales under the assumption that the company continues with as-planned inventory purchases based on predicted growth would put this business into bankruptcy by November.
A company with a negative cash conversion cycle could handle a decrease in sales more effectively and have more time to react, but in this case this company, and all too many new companies, would fall into bankruptcy. One way companies can mitigate this task and this event to outsource it to a 4PL, which can fulfill your orders and manage your inventory strategically.
One of the most famous companies of recent times to successfully use negative cash conversion cycles is Gymshark, which had a negative cash conversion cycle of around 60 days in 2020. They were able to sustain most of their growth without taking outside funding because they were paid for their product prior to having to pay for their inventory. This is due to several factors, including the fact that Gymshark sells its products online, which allows it to collect payment from customers quickly. In addition, the company has built strong relationships with its suppliers and is able to negotiate favorable payment terms.
Another example is Dell, a leading computer technology company, which is known for its negative cash conversion cycle. By using a just-in-time (JIT) inventory management system, Dell was able to optimize its cash conversion cycle, leading to improved cash flow and increased profitability.
Amazon, a leading online retailer, is known for its single-digit cash conversion cycle. Amazon's efficient supply chain and inventory management system allow it to keep a lower amount of inventory on hand, enabling it to quickly fulfill customer orders and reduce inventory carrying costs.
While there are plenty of success stories of proper cash management, there are many failed examples of not managing the cash conversion cycle.
RadioShack: RadioShack was an electronics retailer that filed for bankruptcy in 2015. The company had a poor cash conversion cycle, as it took a long time to turn over its inventory and collect payments from customers. This put a strain on its cash flow and made it difficult to invest in new products and technology. In addition, RadioShack had a significant amount of debt, which made it difficult to manage its financial obligations.
Borders: Borders was a major bookstore chain that filed for bankruptcy in 2011. The company struggled with declining sales and increased competition from online retailers such as Amazon. Borders also had a poor cash conversion cycle, as it took a long time to turn over its inventory and collect payment from customers. This put a strain on its cash flow and made it difficult to invest in its stores or compete with rivals.
To improve their cash conversion cycles, businesses can adopt several strategies. One tactic is to optimize inventory levels, ensuring that they have enough inventory to meet customer demand without holding too much. Another strategy is to streamline payment processes, including invoicing and collections, to reduce the time it takes to collect cash from customers. Implementing an efficient supply chain and logistics system can also help to reduce the time it takes to convert inventory into cash.
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