Profit is not cash!
Managing your cash flow is one of the most important aspects to running a business. We have seen in the past few years a number of high profile companies that were supposedly profitable go bankrupt.
The cheapest and best source of cash for a business is the efficient management of the cash conversion cycle (or simply the cash cycle). The cash cycle is made up of three core components:
- Stock management (including work in progress)
- Payment of suppliers
- Collection of cash from customers
We need to keep a close eye on these components and the actual cash in the bank. If there are any leakages in these components then we may have additional costs hindering our financial performance. These costs may include extra interest charges for the overdraft, missed opportunities or loss of reputation when not paying creditors promptly.
The cash cycle is the length of time it takes from purchasing your stock till you receive payment from your customer. We can measure this cycle with the following performance indicators:
- Days Inventory – the average number of days your stock is held before being sold.
- Days Receivable – the average number of days to collect cash from your customers.
- Days Payable – the average number of days to pay your suppliers.
The Cash Cycle = Days Inventory + Days Receivable – Days Payable.
Generally, the shorter the number of days the better. However, it is not recommended that you hold off paying suppliers to reduce your cash cycle. The cash cycle needs to be compared to industry norms as well being reviewed for efficiency.
There is an excel spreadsheet available on the resources page of my website that calculates the cash cycle for you.