Calculating Your Business Cash Needs with the Cash Conversion Cycle

As a commercial banker who’s been working in the industry for over 20 years and having also spent a good number of years as a consultant to rapid growth second stage businesses, I always enjoy the conversations that arise. I feel like I learn new things every day talking to business operators. On the other hand, there are many times when I find myself having the same conversations with so many of the companies I’ve worked with. When I talk to business owners – especially companies that are graduating to the next level due to experiencing amazing growth, one of the topics that always come up is their need for financing.  

I can’t tell you how many times I’ve sat down with a company who shared how all their problems would be solved if they could just get that line of credit for their business. This always leads me to delve deeper on a couple points:  

How much financing do you need? and Is debt really the only solution?

When I ask these questions, I can usually see the gears turning as they start to think about it a little more deeply. Many times, the company I’m talking with is relying on me as the banker to help them understand the financing amount...and usually they are basing it on one question which is “How much do I qualify for?”  

The problem with this way of thinking is that it assumes debt is always a solution and never a problem which is the wrong assumption. Debt is a tool like any other. It’s a source of cash for a company but it comes with some strings attached – you have to pay it back and you have to pay interest! Once we start digging into the details on that, the other consideration is whether debt is the only solution and most of the time it is not. This is where we start to talk about cash management. And no discussion on cash management is complete unless you consider the Cash Conversion Cycle.

I’ve attached a handy spreadsheet here that you can download and use for assessing your own business. I used that same spreadsheet to work through the example below and I'll share some screenshots as I talk through how to use it. To do this, you’ll need your company’s Income Statement (otherwise known as a P&L or – Profit & Loss Statement) as well as a Balance Sheet. As you are working through this, you’ll notice that some cells in the spreadsheet are shaded yellow. These are the formula cells that auto calculate so you should not type anything in these cells ever.  

I plugged in the numbers for a sample company here on the first tab of the spreadsheet and all of these figures came from the Income Statement.  

Next, I went to the sample company’s Balance Sheet and filled in the corresponding figures on the second tab of the spreadsheet.

‍Understanding the Cash Conversion Cycle (“CCC”)

Notice that there is a third tab on the spreadsheet. That tab is the one labeled Cash Conversion Cycle (“CCC”). CCC is calculated as:  

Inventory Days + AR Days – AP Days = CCC

When we talk about trade days in AR, AP, and Inventory we are talking about the time it takes to convert from a trade asset (in the case of Inv or AR) or a trade liability (in the case of AP) into cash. Remember that AR and Inventory are a use of cash and AP is a source of cash. Some people find this to be counterintuitive at first glance, so here’s a way to better understand:  

• When your AP grows, it is because you are NOT paying for something…you owe another party money for it. So, that is a source of cash - because you have more cash now since you are not paying your AP. Same thing goes for debt - if you have an increase in debt that is a source of cash. When you borrow $100k you now have $100k of additional cash on the balance sheet, even if you have to pay it back later. Remember that a balance sheet is a snapshot of a single day in time (the date of the balance sheet). This differs from an income statement which is showing you the flows of cash over a given time period (usually a fiscal or calendar year, but sometimes an interim time period)
• When your AR and Inventory increase, what is actually happening is that you took your cash and used it to buy the raw material needed to create the finished product that will eventually be sold. The more AR and Inventory you have, the less cash you have.

Bottom line: An increase in Assets is a USE of cash. An increase in Liabilities is a SOURCE of cash.  

Now getting back to that Cash Conversion Cycle tab on the spreadsheet, you see that this company shows:

Inventory Days = 22.23 days (average time it takes a company to turn inventory into sales)

AR Days = 70.38 days (average time that an invoice is outstanding before it is collected)

AP Days = 17.99 days (average time it takes a company to pay its suppliers)

So, their CCC = 74.62

This is what it looks like on the spreadsheet -  

Something interesting here…this company is paying their suppliers in about 18 days on average but it’s taking them over 90 days average (AR + Inv days) to convert their investment back into cash flow. The company is buying inventory, taking 22 days to convert that inventory to AR, then taking another 70 days to collect on the AR.  

As I analyze this, I would share some questions and comments with this company that went something like this -  

1. Can you help me understand why you are paying your AP so quickly?  

                a. There could be a reason. Maybe you will get discounts if you pay quicker. Are those discounts significant enough to justify the faster payment?  

                 b. What is your cost of capital? If you are getting a 5% discount for paying AP faster but it’s leading you to spend more money on short term financing vs using your own cash for AR and Inventory investment, maybe you need to reconsider that.

2. Are there better ways to do this? Can you use a credit card and pay it off at the end of each month, so you don’t incur interest?  

                 a. For example, if you were to pay all your AP with some no interest or low interest credit facility that gave you 30 days to repay, your AP days would increase from the existing 18 days to 30 days…that means you would reduce your CCC by 12 days. What is 12 days of interest worth to you when it comes to interest expense? It could be big money depending on the interest rates you pay for credit and the amount you have to borrow!

3. You have a fairly significant amount of AP for a company in your industry. I bet your suppliers like you. Anything you can do to work on more flexible terms, so you are not forced to pay them in 18 days on average?  

There may be logical reasons that this company knows and I don’t know which would explain why the above questions are irrelevant. What I am sharing here is what any experienced analyst or consultant would consider at first glance just based on the story that their financial statements tell.  

Estimating Company Cash Requirements

Now to estimate a company’s cash requirements based on CCC.  

Take the company’s total projected sales / 365 (days in the year) x CCC.  

I’ll do an example based on the same company we’ve been working with:  

The company in this example closed out their prior year with $3.2 million in sales.  

$3.2 million / 365 = $8,767 x 75 days CCC = $657,525

Now remember what I said above about stretching their AP days from 18 to 30 which would reduce their CCC by 12 days:  

$3.2 million / 365 = $8,767 x 63 days (because we reduced their CCC 12 days by stretching AP) = $552,321.  

So, by shaving just 12 days off their CCC this company can reduce their cash needs by over $100,000!  

This is something many business operators fail to see at first glance.  

You can increase your AP and decrease your Inventory and AR to greatly reduce your cash requirements.  

I hope that is an illustrative example for you to consider in your own business. It shows how you can resolve cash flow shortfalls with methods other than simply taking on more debt. Consider your cost of capital, sources of capital and the related benefits/drawbacks of each source.  

Also look at the AP side and see what you can do to stretch AP without adversely impacting supplier relationships. Imagine if your suppliers were able to give you 45 days instead of 18 days. You just cut your CCC by 27 days! Do the calculation above and see what that does to your cash requirements.  

Some of the larger banks out there just seek to keep you in debt and offer no other solutions or consultation. Just check your mailbox and see how many credit card offers you got today if you don’t believe me!  

Here at Climate First Bank, we act as trusted advisors to our business clients. We realize that loans and lines of credit are just one component to the financial health of a business. In terms of cash management, we have an expert team on staff here positioned to help you maximize your cash flow with a variety of convenient commercial banking services. And we do it with the industry’s best pricing! Check out our NetZero Business Checking account with no minimum balance, no monthly service charge, and free ACH and Positive Pay services included! These services help you to get paid quicker and keep your accounts as secure as possible. Reach out to us to learn more today!

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