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Cash Constraint-identification, corrective actions, and prevention.

Authors: Ravi Gilani & Ira Gilani

Executive Summary

Prior to early 2000’s, the common understanding in the TOC community was that an organization
could have a physical constraint in only one of the three areas: orders, supply or operations. In each
of these areas, exploiting the constraint will increase the throughput accordingly or linearly.

In 2001, was cash was also identified to be a physical constraint. Cash constraint is a special
constraint in which exploitation, and subordination of the constraint impacts throughput non-linearly.
Exploitation and subordination of cash also elevates the cash constraint.

1. Constraint Identification

We can quickly identify the physical constraint through the following algorithm.

• Order constraint: An organization has a constraint in orders if its OTIF (On Time In Full) is
consistently above 90-95%.
• Supply Constraint: An organization has constraint in supply if material availability is less than
95% despite paying vendors on time.
• Operations Constraint: Any organization that is unable to deliver OTIF consistently above 90-
95% despite having input material availability has a constraint in operations.
• Cash Constraint: When an organization has OTIF less than 95% and is unable to get input
materials on time due to its inability to pay suppliers on time, it faces the worst type of constraint
i.e. cash constraint.

Cash shortage is not the same as cash constraint, though cash shortage will lead to cash constraint in
due time. Despite cash shortage, it is possible that supplies do not suffer on account of vendor
payments, at least for a short while. If not corrected, the cash shortage can lead to cash constraint.

In such a case, money is both the goal and the absolutely required capacity to continue the business.
This is a unique situation with very critical ramifications, which should lead the management to
behave differently than in any other state. When lack of cash threatens the existence of the
organization all the attention of the top management is consumed in fighting one payment crisis after
another.

(Taken this para from article with Eli S: https://elischragenheim.com/2017/05/11/evaporating-an-

active-cash-constraint/)

An organization has a cash constraint if and only if:

1. OTIF < 95%
2. Adequate number of suppliers and yet it suffers from material shortage as suppliers are not
getting payments on time
3. Additional funds cannot be arranged easily

2. Non linear impact on throughput, sales, and cash availability in a cash constrained
organization

We will examine two situations of an organization having following parameters that is currently in cash
constraint.

• Raw material or totally variable cost (TVC) cost assumed as % of net sales = 50%
• Throughput as % of sales = 50%
• Cash to cash time i.e. cash outflow to cash inflow time = 1 month
• Current capacity utilization is 50%
In the precariously balanced organization there is just about enough cash to survive.

Table 1: Precariously balanced system

Table 2: Slight decrease in cash at the beginning of month 2

In this case a very small decrease in cash availabity is sufficent to make the organization bankrupt.

The downward spiral caused by a small decrease is the unique property of cash impacting throughput
(contribution), sales, and cash flow non-linearly. Similarly a very small increase in cash will increase
throughput, sales, and cash exponentially.

3. Why do companies get into cash constraint?

The prime reason for getting into this situation is the wrong overall global organizational
measurement. Most organizations measure their growth either in terms of sales turnover or volume of
product sold. Some organizations do focus on increasing Profits after tax (PAT). However very few
organizations measure their performance in growth of Free Cash Flow (FCF). In fact it is quite
common that an organization declares healthy PAT but has negative FCF.

Let me share in very simple terms the relationship between PAT and FCF.

PAT is the net profit after deduction all expenses from the net sales.

FCF is the net increase in cash availability in the bank before taking or repaying loans.

FCF = PAT + Depreciation (Non cash expense) – Increase in working capital – all capital investment
As shared earlier most organizations focus on increasing sales though a few also try to increase
profits. But if the increase in working capital is more than PAT + Depreciation / non-cash expenses
then it results in negative FCF.

4. Application of five focusing steps to cash constraint

Step 0: Decide the correct overall organization measurement. Measurements drive behaviour!
In a cash constrained organization, the key parameter to focus on is not sales, not profit / loss or
even throughput. It is Free Cash Score (FCS).
FCS = Throughput (T) – Operating Expenses (OE) – Income tax + reduction in Investment (I) +
reduction in vendor overdue payables.
Most cash constrained organizations also make losses; hence income tax may not be there. Similarly
it may not also be investing in acquiring additional plant, and machinery etc. Accordingly the
reduction in I will only be from depreciation included in OE and decrease / (increase) in working
capital (accounts receivables, + inventories – vendor payanles). Since it may be possible to increase
the FCF by delaying the vendor payments, we recommend FCS as it will reduce when vendor
overdue payables go up or increase when vendor overdue payables are reduced.

Once cash has been identified as the organizational constraint (strictly based on the conditions
described above), the next step is exploitation of the constraint.

We can use the standard PQ case study here too for exploiting the constraint resource. In the
standard PQ case, operations is the constraint-more specifically it is the capacity of resource B. The
prime metric for giving priority for selling product P or Q is the throughput per unit time of constraint
resource B. In cash constraint situation cash is the constraint. Here also we use a metric cash
velocity for decision making for prioiritizing selling P or Q. Cash velocity is defined as increase in
cash per unit of cash per unit of time. Since cash increase or decrease impacts all the relevant
parameters non linearly, cash velocity is calculated by the formula

(S/TVC)^(1/ N )-1, where S is the unit selling price, TVC is the unit totally variable cost, and N is the
cash to cash cycle time.

In our precariously cash balanced organization example, the truly variable cost (TVC) is 50% of sales
and the cash-to-cash cycle time is one month. In other words, an incremental cash induction of $50
will become $100 in one month’s time. Here, the cash velocity will be 100% per month.

Cash-to-cash cycle time is the total time from cash outflow to cash inflow in the system. In other
words the time from the actual payment to a supplier until the client pays. We can measure the time
by days or weeks or months.

If the company has inventory of 2 months, receivables of 1 month, and payables of 1.5 months, the
cash-to-cash cycle time will be calculated as follows:

Cash-to-cash cycle time = Inventory (in months) + Receivables (in months) – Payables (in months)
= 2.0 + 1.0 – 1.5 = 1.5 months
Table 3: Cash Velocity for two different products P & Q.

Parameter P Q

Selling price per unit (S) in $ 100 80

Truly Variable Cost per unit (TVC) in $ 50 50

Manufacturing lead-time in weeks 2 2

Credit period in weeks 4 1

Cash to cash cycle time (n) in weeks 6 3

CV/ Week ={(S/TVC)^(1/n)}-1 12% 17%

In the above table, selling Q is preferable because it would generate cash faster. In cash constraint
situation, the focus is on generating as much cash and as fast as is possible through effective
utilization of existing cash. A small increase or reduction in cash can make or break the
organization. This unique property of cash impacting throughput non-linearly could help organizations
to overcome cash constraint in a very short period of time. In most cases it may be possible to come
out of cash constraint in less than three months by reducing cash to cash time, and by that
accelerating the cash velocity. Often just shrinking cash to cash cycle time is good enough to come
out of the cash constraint situation provided the right measurements are in place.

Reduction in customer payment time

More often than not, customer payment time is the single largest component of the cash-to-cash cycle
time. Most managers think that when we reduce payment time by one week, we save interest cost
only for one week. It is extremely important to note that even this small decrease in cash-to-cash
cycle time increases cash velocity significantly, and thereby impacts throughput non-linearly. As we
can get huge benefits from shrinking customer payment time, we must explore all possibilities
including significant discounts for immediate payment.

Giving the customer price reduction in exchange of significant faster payment is of paramount
importance for achieving faster CV. It can be shown that even after providing 20% price discount to
shrink customer payment time from 4 weeks to one week could exploit better the cash constraint,
and thereby increase cash in the system.

Shrinking manufacturing lead-time

Drum-Buffer-Rope (DBR), the production solution of TOC, shrinks the manufacturing lead-time by a
factor of 2-10. This is particularly effective where manufacturing lead-time is a significant part of the
cash-to-cash cycle time. For organizations that make capital goods, these tools help immensely in
reducing manufacturing lead-time. In several cases, this paves the way for increased selling prices by
offering reduced lead-time. Companies that make to stock also benefit by reduced Work In Progress
(WIP), and finished goods inventory, thereby releasing cash.

Buying small quantities more frequently

This aspect is often overlooked and companies pay heavily by not examining supplier policies in a
cash constraint situation. Reduction in supplier MOQ (minmum order quantity) is one of the important
means of crashing the cash-to-cash cycle time as the raw material inventory holding requirement
comes down with more frequent purchases of small quantities. In some cases, it may also be
worthwhile to switch to a supplier who has a higher price per unit but is willing to supply in small lots
reliably. This may impact the gross contribution or throughput (though not significant) but it can shrink
raw material holding time. These decisions should be taken after evaluating the impact on affected
parameters such as input price increase, reduction in cash-to-cash cycle time, reduction in raw
material inventory requirement, and most important, improvement in cash velocity.

While the above may seem like common sense, often this is not common practice. Local
measurements or departmental KRAs (Key Result Areas) often prevent companies from adopting
these practices that can prevent bankruptcy.

All functions, departments, decisions should be aligned to get the most out of the constraint. In our
experience, subordination is often the most difficult to implement as it requires changes in existing
practices and policies of local optimization.

Many organizations waste their most precious asset cash for purchasing more than immediate
requirement just because the purchase team can get a volume discount by buying additional
quantity. In turn, this additional cash outflow starves the organization of other required materials,
thereby jeopardizing full material availability. It has often observed that dispatches are held up
because non-availability of one of the insignificant inputs. This increases cash-to-cash cycle time and
hastens bankruptcy. It is recommended to buy just the minimum quantity required for making ‘Full Kit’
for immediate production.

Similarly, chasing local optima in manufacturing invariably leads to more production than immediate
requirement to achieve better capacity utilization. Plant managers produce more quantity of some
products to save on set-up times. The additional production not only blocks cash and increases cash-
to-cash cycle time but also delays other important products and disrupts the flow.

There is one common behavior that has been observed in almost all cash stressed units.
Organizations are extremely reluctant to change current business practices be it in buying materials,
manufacturing, or in selling. An actual case study is shared below.

This client organization was in the business of making electrical switches. It declared a loss for the
first time after making profits for continuous 42 years. Situation became extremely critical as
suppliers stopped supplying input material unless paid upfront. As a consequence, its capacity
utilization dropped to less than 20%. Its TVC as percentage of net sales was 40%, manufacturing
lead-time was 3 days, and realization time was 60 days as it was selling primarily to retailers.

Every additional inflow of Rs. 40 would generate additional sale of Rs. 100, resulting in cash inflow of
Rs. 100 after 63 days. This means every additional Re. 1 will get converted to Rs. 2.5 after 63 days.

A suggestion was made to shrink collection time even by offering up to 50% discount for immediate
payment. The instatneous response was that it will increase the loss even more.

Here are the calculations.

For every addition of Rs. 40, the sales would only be of Rs. 50 (50% of 100). However, the cash to
cash cycle time now gets reduced to 6 days (3 days for manufacturing and 3 days for getting the
credit in the bank).

Or for every additional Re. 1 will now generate cash of Rs. 1.25 only but after 6 days. After another 6
days, the Rs. 1.25 realized would generate Rs. 1.56 (1.25 X 1.25). Continuing this for 60 days, the
initial Re. 1 would get converted to Rs. 9.31 - a little less than four times of Rs. 2.5 being generated in
the conventional way! Of course it is assumed that we have adequate orders and sufficient
operational capacity.

This organization offered this proposal in a segmented market and turned around in less than 3
months! Segmented markets are those where any volume sold in one segment does not impact
volumes and prices in other segments.

There is no magic in this. All we need to work out the rate at which cash is being generated in one
period of time. In this example, the existing cash velocity was about 55% per month and in the
suggested proposal it was 205%. Ten years later this company was sold to a multinational
organization for about Rs. 650 crores (US $ 150 million)!
In most situations, recognizing that cash is the real constraint, exploiting and subordinating all
organizational measures and policies to the cash constraint will shift the constraint either to orders or
operations within 13 weeks. However, in extreme situations it may be necessary to elevate cash i.e.
induct additional cash. For cash stressed organizations, cash may be available only at significantly
higher rate of interest. Here we must understand that for most organizations the cash velocity varies
from 10% to 30% per month. Hence, it makes sense to borrow even at very high rate of interest so
long it is significantly less than cash velocity. Another caveat is also in order. Partial induction of
cash will not work. Either induct the total minimum required cash at one go or none at all!

Table 3: Partial induction of cash

Total cash inducted in 4 stages = $40

Table 4: One-time induction of sufficient cash

Total cash inducted in one go = $30

The main obstacles in overcoming cash constraint are the local measurements (sales, market share,
tonnage, freight cost control, interest cost control etc.) that organizations continue to improve when in
cash constraint. Continuing to use the same measurements lead to further deterioration of the
situation and must be done away at all costs.

Companies do not fold up when they make losses. Rather they close down when they run out of cash.
Survival time is the period of time in which the existing cash in hand can cover fixed expenses. Any
action that has beneficial impact after the survival time is irrelevant. All actions should be taken to
increase survival time by shrinking cash-to-cash cycle time.
Preventing cash constraint through Cash Buffer

Step 5 of the POOGI is “Go Back to First step”. In fact it is to choose the constraint. Constraint could
be in operations or orders. However cash must never be the constraint.

It is possible to shift cash constraints in a few months, and in due course constraint will be in
operations / orders.

As the Goal of the company is to make more and more money, throughput increase is almost a must.
In most cases it will demand an increase in sales. This in turn will require increase in investment in
the form of higher accounts receivables, and inventories.

In order that cash does not become constraint again while the sales is increasing, the organisation
must have protective capacity in cash as cash buffer. The amount of cash that should be kept as
buffer depends upon the uncertainty in managing working capital with planned growth rate of sales.

The cash buffer can be worked out keeping in mind the following parameters.
• Cash buffer should be adequate for a certain number of months for OE so that the
organisation has no problem in making payment for fixed expenses, should there be no
inflow of money
• in addition, it should cover the amount of account payables that must be paid while
inflows may not happen
• Cash buffer should also be able to cover additional demands of working capital when the
sales is growing

It is helpful to project cash inflows and outflows statements for next 13 weeks.