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60 days DIO + 45 DSO - 40 DPO = 65 Days
In this example, FreshFabric has a 65-day cash conversion cycle. It means it needs 65 days of working capital to purchase inventory and convert it to cash.
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What Does a Negative Cash Conversion Cycle Mean?
A negative or steady cash conversion cycle suggests that the company has a high inventory turnover rate and sells its inventory prior to paying for Stock Keeping Unit.
SKU is a unique identifier assigned typically by a manufacturer or a retailer to track inventory and is usually associated with a barcode.
On the other hand, a positive cash conversion cycle indicates that the company’s working capital is constrained until the accounts receivable are paid.
As with any improvement initiative in your company, you wouldn’t know where to begin unless you know where you stand currently.
The first step to improving your CCC should always be calculating the average time it takes for your company to recoup your investment.
You may have the opportunity to improve your business’s cash flow if it’s anywhere longer than 30 days.
7 Tips to Improve Cash Conversion Cycle
1. Closely Monitor Working Capital Metrics
To improve your cash conversion cycle, it’s important to closely monitor and adjust your working capital metrics: DIO, DSO, and DPO.
To adjust the DIO, for instance, developing good working relations with your suppliers helps because it helps manage just-in-time (JIT) and eventually reduces inventory shelf life. JIT inventory management is when you receive only the exact amount of inventory you need right when you need it.
For DSO, offering early paying discounts encourages your clients to pay their invoices early. Other good strategies are to shorten the accounts receivable terms, such as from 30 days to 15 days, and to improve the collection process.
These strategies speed up the time it takes to collect payments. However, find a balance in the collection process in such a way that it will not negatively affect your relations with your clients.
For DPO, it’s better for your CCC if you have a longer time to pay for inventory. Still, it’s important to manage this strategy carefully to balance the potential disadvantage of the stress it puts on your supplier relationships against the benefit to your cash flow.
2. Modify Your Accounts Receivable Payments
It may be a viable option for your business to request a deposit or upfront payments. Immediate payments increase your cash flow and improve the cash conversion cycle.
Using an automated accounts receivable system is also an efficient way to improve cash flow because it leverages your return on investment. Lager changes, such as changing banking systems or improving supply chains, may take a long time and cause disruptions.
A/R solution is simple and provides long-term benefits.
3. Disburse Your Accounts Payable Slowly
Paying your invoices according to the terms agreed with the suppliers is recommended, but you won’t benefit from paying early. It increases your cash on hand if you disburse your AP later.
So, if you want to increase your cash on hand, you can set up an accounts payable management system with the help of your accounting department.
Such a system will be where all invoices are paid close to the due dates rather than early.
4. Evaluate Vendor Stability
Financially healthy vendors lessen the risk of supply chain disruption, which may affect your top and bottom-line revenues.
Moreover, reliable vendors make it easier to improve production and the supply chain. All these help improve your cash conversion cycle.
For instance, if you can rely on a vendor to deliver on schedule or as promised, it becomes easier to optimize production campaigns and limit the time the inventory sits until it's sold.
Related Reading: Streamline Your Finances: Effective Small Business Accounting Tips
5. Launch a Pre-Order Sale
Offering pre-orders is an effective and easy way to collect cash upfront before paying for the inventory. It likewise helps you better predict demand.
The biggest advantage of a pre-sale is there’s no e