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Unveiling the mystery of “Cash Conversion Cycle”; how to show your lender that you understand your business’ cash flow
Special thanks to Ken Daley of Citizens Bank for his help in writing this article (Disclaimer: Ken Daley’s contribution to this article is not necessarily endorsed by
Citizens Bank and is independent of his employment there.)

Part I – Cash Conversion Cycle Several years ago I was reviewing a loan request for a $100,000 line of credit from a fulfillment company (let’s call it ABC Fulfillment; ABC was in the business of stocking inventory from businesses and individuals, then taking orders and shipping those goods to various buyers). During my first meeting with the owners I gathered preliminary information about the company, its owners, and the industry in which the company competed. One of my burning questions was how familiar are the owners with ABC’s cash conversion (defined below). Cash conversion is what would ultimately repay my bank’s line of credit, interest, and other fees related to deposit accounts and a range of other bank services. I was impressed when the owners of the company explained how the cash flowed in the company: Inflows of cash: 1) retail orders were paid mostly by credit cards (equivalent of cash) with retail orders accounting for 40% of sales; 2) orders from businesses were paid within 30 to 60 days. Outflows of cash: 1) individuals and companies that utilized fulfillment services of ABC typically got paid once a month, when ABC sent them sales proceeds minus various fulfillment fees that belonged to ABC; 2) employees were paid twice a month; 3) accounts with delivery companies were settled twice a month; 4) various business (operating) expenses were commonly paid once a month. I was impressed because a considerable number of small business owners do not have a good understanding of their companies’ cash conversion. This in turn affects their understanding of how much money they need to borrow and, in some instances, results in a declined loan. To help you understand and explain to your prospective lenders your company’s cash conversion, let me introduce you to the financial concept known as “Cash Conversion Cycle”. Do not be intimidated by financial terminology, it is easier to grasp than you might think. This concept is what lenders frequently focus on when analyzing small business loan requests. Knowledge of your company’s cash conversion can increase your chances of getting your loan approved. To illustrate the Cash Conversion Cycle, let’s take a look at the images at the end of this article (page 5-7). I included the Cash Conversion Cycle illustrations for manufacturing, retail/wholesale, and service companies. The majority of small businesses will fall under one of these charts.

Copyright © 2006. D. Neil Berdiev. All rights reserved.

ABC turned around and sent payments to its various vendors (individuals and companies that provided inventory for sale. As a result. All rights reserved. this is not the case for most small businesses I worked with. took purchase orders. However. and packaging vendors). which means that you may need to borrow money for short periods of time. Accounts Receivable Collection Period. What does this number [15 days] mean? It means that the company’s cash was tied for 15 days in accounts receivable and the owners had to come up with cash to temporarily cover the gap. sell. ABC does not need to borrow money from outside (ABC’s operations should be funded from what finance people call “internal cash flow”). and collect money for your products and services.2 Cash Conversion Cycle is the amount of time it takes you to produce. It is calculated as shown below: Cash Conversion Cycle = Inventory Days on Hand + Accounts Receivable Collection Period – Accounts Payable Payment Period If your company provides only services. ABC paid its vendors in 30 days. This is where lenders frequently come into play. delivery companies. if receivables are collected within 30 days and payables are paid within 30 days. D. which means that the money earned was not available for 45 days. ABC collected its receivables within 45 days. ABC Fulfillment simply stored the goods in its warehouse. its customers paid for it and sent it to ABC’s warehouses. and shipped goods to buyers. cash it earns and receives should be greater than expenses it pays. the company did not purchase inventory. Thus. then the formula will look as follows: Cash Conversion Cycle = Accounts Receivable Collection Period – Account Payable & Compensation Payable Payment Period Explanations of how you can calculate Inventory Days on Hand. let’s calculate the cash gap your company needs to fill before accounts receivable are collected. . Let me give you another example that should clarify things. Copyright © 2006. Neil Berdiev. If ABC is profitable. ABC did not tie its cash in inventory. The Cycle is calculated in days. Now that you know the length of your company’s Cash Conversion Cycle. and Accounts Payable Payment Period are provided at the end of this article. Multiply Cash Conversion Cycle measured in days by average daily sales [annual sales / 365]. This means that as soon as cash arrived from customers (individuals and companies that bought inventory from ABC’s warehouse). In the example of ABC fulfillment. Note that the formulas are a mere reflection of how many days your company’s cash is tied up in inventory and accounts receivable and how many days it takes you to pay your supplier and vendor bills. Receivables were eventually collected but until that time ABC needed to find money to cover its obligations to suppliers and vendors. Let’s imagine that ABC Fulfillment collected its accounts receivable in 30 days and paid its payables also in 30 days. Therefore. ABC Fulfillment’s Cash Conversion Cycle was 15 days [45 – 30 = 15]. Vendors usually want to get paid faster than your customers are willing to pay. Most commonly businesses will apply for lines of credit to cover the so called temporary cash flow shortfall.

laundry companies.3 Cash need = Cash Conversion Cycle x [Annual Sales / 365] Of course. If you have a good relationship with your suppliers and vendors and always paid within agreed timeframe (e. However. 1) Supplier or vendor financing or what we lenders call spontaneous sources of financing. determine how much money you need to request from your lender. However. Faster inventory turnover could be achieved by making changes to your sales force or how you motivate them. Part II – Learn to manage Cash Conversion Cycle So. Here are few thoughts on how you can generate additional cash before putting in some of your personal cash or using lenders’ money. and even refuse to do business with your company. Some of the most common reasons for cash flow shortfalls (need for additional cash) are long inventory turnover. This is the cheapest financing you can secure. growth (particularly excessive growth pace). stretching payment terms beyond certain point may cause your suppliers and vendors to tighten credit terms. requesting to pay within 30 days can keep additional cash in the company. 2) Faster inventory sales and faster collection of accounts receivable. you still have accounts payable to pay and you pay them most likely once a month or more frequently but not daily (e. commonly 30 to 60 days. Suppliers usually do not charge you interest or fees. In addition. if you do not understand how cash flows in your company. Neil Berdiev. and seasonal sales fluctuations. relatively fast payment of accounts payable. such as a restaurant or a convenience store. Even if your business is primarily a cash business. . low or negative profitability. g. paper and plastic products’ suppliers). what is Cash Conversion Cycle? It is a measure of your company’s liquidity. As soon as you understand how your cash flows and are able to calculate your cash conversion cycle. if any. All rights reserved. Why must you understand and be able to explain your company’s cash conversion? Well. You can also consider changing your purchasing patterns to move closer to a just-in-time inventory management system (stocking just enough inventory to meet your anticipated sales). the Cash Conversion Cycle discussion can get more complicated and involved and there is more than one approach to calculating the cash need. D. as understanding how your business’ cash flows and where it gets tied is the first and most important step to understanding your business’ cash flow situation. Liquidity describes your company’s cash flow and more specifically the difference between cash inflows and outflows and its additional cash need. All you need to do is persuade your suppliers or vendors to allow you to pay in a certain number of days.g. These are the tools at the disposal of almost every small business owner. to produce suppliers. Copyright © 2006. 15 days). you will be able to estimate how much money you need to borrow from your lenders to cover temporary cash crunch situations. and make a credible case to support your loan request. charge fees and interest. slow collection of accounts receivable. the cost is $0. offering your customers discounts and other incentives can help move inventory. you will not be able to make changes or improvement to cash flow. I’d like to stop here.

which is 7. Neil Berdiev. faster receivables collection will generate more cash for your business. loans from commercial lenders are one of the least expensive sources of cash after spontaneous financing.4 I frequently see many opportunities for small businesses to improve cash flow by improving receivables record-keeping and putting more efforts into collecting money faster.g. that is if putting in additional personal cash is not desirable or convenient. the next stop for financing is a lender.5% to 9. Many small business owners do not have the option and often the desire to bring in outside investors.g. Keep in mind though that aggressive receivables collection may turn your customers away. Many traditional lenders (e. By the same token. +1%. your return will probably be in the range of 20% to 30% or higher. which may carry interest rate of Prime plus 3% to 6% or 10. This is frequently easy to achieve and can produce unexpectedly positive results. Venture capital is usually not an option for a small business based on typically high (required) rate of return. Therefore. +2%). leasing company. This is usually cheaper than going to a financing company (e. Monthly payments are interest only with principal reduction expected when cash flow is positive. All interest rates are determined based on the credit worthiness of the company. .5% at the time this article was being written. Also note that if lenders lend you money against accounts receivable. After you exhaust your spontaneous financing sources. All rights reserved.5% to 13. faster collection in theory will reduce your accounts receivable and reduce the amount you can borrow. Again. Knowledge of your company’s cash flow and understanding of the Cash Conversion Cycle will help you correctly estimate the need for loan financing and make a more persuasive case to lenders to grant you loans. This return includes a return on your investment and your time spent on managing the company. If you were to put a price tag on your money or the return rate you would expect. D. this approach to generating additional cash for your company does not require interest payments. commercial banks) will typically give you lines of credit at Prime rate plus a small spread (Prime+0%.5% and higher. asset-based lender). *** Copyright © 2006.

. D. Neil Berdiev.5 Manufacturing company Cash Conversion Cycle Copyright © 2006. All rights reserved.

D. Neil Berdiev. All rights reserved. .6 Retail/wholesale company Cash Conversion Cycle Copyright © 2006.

Neil Berdiev Copyright © 2006. Neil Berdiev. All rights February 2006 D. D.LoanFinancingGuide. .7 Service company Cash Conversion Cycle FORMULAS Inventory Days on Hand = [Inventory Balance / Last 12 months Costs of Good Sold] x 365 days Accounts Receivable Collection Period = [Accounts Receivable Balance / Last 12 months Sales] x 365 days Accounts Payable Payment Period = [Accounts Payable Balance / Last 12 months Costs of Good Sold] x 365 days Published on www.