Understanding the cash conversion cycle (“CCC”) for your business is paramount to effective cash management, and we all know CASH IS KING for a growing business. The CCC measures the amount of time it takes to produce, sell, and be paid for your products and services. The cycle is calculated in days as shown below:
CCC = Inventory Days on Hand + Accounts Receivable Collections Period – Accounts Payable and Payroll Payment Period
Using this formula will allow you to calculate the number of days your company’s cash is tied up in operations and unavailable for other uses. If you know the number of days of your business’ CCC, you can plug that number into the following equation to determine your company’s cash flow gap:
Cash Need = CCC X (Annual Sales/365)
An effective way to manage the CCC and reduce your company’s cash flow gap is to reduce the average collection period from your customers.
When your customers experience cash flow limitations you often end up supporting them by allowing them to carry amounts owed to you for extended periods of time. You have already paid your employees and suppliers for the labor and materials to produce your product or service. You have paid these costs using your own equity and/or financing, both of which come at a cost. When your customers do not pay within terms they are essentially using your equity and financing for free. You are now serving as your customer’s bank!
If you were paid cash on sales instead of having to offer terms to your customers you would never have a cash flow problem. However, businesses typically demand terms because they too have similar challenges with their cash flow.
Say you solved your cash flow challenges by finding an Asset Based Lender (“ABL”) who understands your business. Your lender is essentially providing you the cash on sales you need to run your business. However, the story doesn’t end here. This financing needs to be managed. The best way to do this is to make sure your loan is performing as a direct result of getting paid within the terms you establish with your customers.
If a customer has fallen past due on paying your invoices what do you do? With some of your customers you may want to increase collection efforts. However with certain customers that you have a strong relationship with and rely on for repeat business, you may want to try a different approach.
Have you ever thought of referring your customers to your lender? If your lender has provided you with financing that allows you to have the working capital you need to manage and grow your business then your lender may be able to help some of your customers, which will in turn help you!
If you have a customer who is slow paying or inconsistent in their payment habits, try starting up a conversation with them about how your lender has helped you with your business. If the response is positive, ask your customer if they would like your lender to contact them or if they prefer, give them the name and number of your lender.
Good advice is almost always well received. This may be some of the best advice you can give your customer, not only benefitting them, but also ultimately benefitting you!