Preface: What is the benefit of all this management of accounts receivable and inventory and accounts payable, i.e. the cash conversion cycle components? Naming only two characteristics: 1) improved liquidity, and 2) more efficient use of working capital.
Cash Conversion Cycles (Segment II of II)
By Jacob M. Dietz, CPA
Inventory
Mapleberrytown looked at some industry standards that their accountant gave them for inventory days, and they realized that the industry is at 100 days. They reviewed their historical inventory days, and they realized that 1 year ago they were at 127, two years ago 115, and 3 years ago at 110. They are currently at 130 inventory days.
What can they do? Inventory management is a huge topic. The specifics of inventory management go well beyond the scope of this blog, but they could begin to look for low-hanging fruit. For example, are they overstocking inventory? If inventory is being stocked at too high levels, it ties up cash.
Mapleberrytown realized that they were stocking too much Widget Component B. Their lead time to get it is 2 weeks, but they have a 2-month supply on hand. When the person responsible for ordering was questioned about it, he responded that he is petrified of running out of the product. After sitting down and discussing the needs for that component, however, they developed a plan to have an appropriate stock level without tying up too much cash.
If inventory is a major component of your business, consider taking the time and really learning about inventory management. If inventory management can be improved, it can make a significant difference on the bottom line.
If a company drags out accounts payable too long, however, then vendors may stop selling to the company, or make them pay on delivery. There are also ethical concerns about waiting too long to pay vendors.
Accounts Payable
Last, Mapleberrytown examined their accounts payable practices. accounts payable days are subtracted when calculating the cash conversion cycle because it is a delay in paying cash. From a cash point of view, longer is better.
If a company drags out accounts payable too long, however, then vendors may stop selling to the company, or make them pay on delivery. There are also ethical concerns about waiting too long to pay vendors.
Mapleberrytown compared their accounts payable balances to previous years, and they discovered that the accounts payable days were steadily getting shorter. Next, they realized that their accounts payable days were below the industry standard. They are paying their bills faster than they did in the past, and they are paying faster than their competitors.
Mapleberrytown decided to go ahead and keep paying so quickly. One factor in the decision was that some of their vendors give them a 2% discount if they pay in 10 days.
Benefits of Shortening the Cash Conversion Cycle
What is the benefit of all this management of accounts receivable and inventory and accounts payable? One benefit can be less cash tied up in the business operations. If less cash is tied up in the business operations, then the business may be able to operate without a line of credit, or with a smaller balance on the line of credit. If the business has no line of credit and funds its operations with cash, then more efficient operations may allow the business to have more money in the bank to fund operations if times get rough. Furthermore, if a business is profitable and uses good cash management, some of that cash may be available to invest in business growth.
How healthy is your cash conversion cycle? Do you have money locked away that you wish you could access?
This article is general in nature, and it does not contain legal advice. Please contact your accountant to see what applies in your specific situation.