Whether your organization manufactures a product or sells a service, it takes time for an investment you make in raw materials or employee brainpower to flow back into your company as cash. The most commonly used metric for gauging that time is the cash-to-cash cycle, also known as the cash-conversion cycle.
At APQC, the benchmarking non-profit I work for, we define cash-to-cash cycle time as the number of days between paying for raw materials and components and getting paid for a product. It is calculated as the number of inventory days of supply plus days sales outstanding minus the average payment period for materials.
But how long should you reasonably expect your cash-to-cash cycle to take?
It’s helpful to examine this process by benchmarking against other companies. December’s Metric of Month, which is calculated using data from APQC’s benchmarking database, is based on a sample size of 3,879 organizations.
The worst-performing organizations thus need 80 days or longer to complete the cash-to-cash cycle and recoup the money they put into their goods or services. The best-performing organizations flip their entire cash cycle in just 30 days or less. At the median are organizations who need 45 days to complete the cycle. In other words, some organizations can recover their cash in less than half the time it takes others.
Why Does Cash-to-Cash Cycle Time Matter?
The primary goal of pretty much any organization that sells goods or services is to make money, and the way to do that is to turn inventory into cash. Building up inventory or delivering a service requires a company to invest in the raw materials or people first, assuming they will earn that money back – and then some – later. The faster your company recovers its investment, the more cash it will have on hand to make and deliver more product and make more money.
For most companies, it’s a balancing act to carry enough inventory to quickly respond to customer demand while simultaneously minimizing the amount of cash tied up in inventory and warehousing. At the median, organizations spend 11% of the annual value of their inventory to carry it. Bottom performers spend three times as much as top performers to carry their inventory: 13% compared to 3.4% of annual inventory value. This is money that is tied up and not bringing any value to the company.
A speedy cash-to-cash cycle is especially critical for smaller businesses, as their tighter cash flow often doesn’t allow for lengthy payment grace periods. Many small businesses can manage with a 30-day cash-to-cash cycle, but a 60-day cycle requires twice as much cash reserves. In many cases, delayed payment means that a smaller business must borrow money to finance the next round of inventory. The slower the cycle moves, the more expensive it gets to produce your product.
The same principle applies to companies that don’t have physical inventory, but do have people who have to get paid to deliver a service to customers. Once you’ve invested money in people to deliver a service — whether it’s in the form of salary, benefits, or specialized training — you need to make money off that person’s expertise. If you’ve already paid your consultant to go into a client’s business and do a job, but then the client spends months disputing the invoice, you’re still on the hook for your consultant’s ongoing paychecks.
How to Speed Up Cash-to-Cash
Like many processes in finance, there are benefits to be gained by increasing speed and efficiency at pain points throughout the cash-to-cash cycle. Incentives and disincentives can also be put into place to encourage faster payment. Following are six tips on how you can speed up the process.
Don’t offer extended terms. The longer you allow your customers to delay payment, the more your company is acting like your customer’s bank instead of a money-making outfit. Of course, telling your best customers “no” when they ask for an extension is easier said than done. But remember: Standing your ground on payment terms means more money to help your company better serve all of its other customers, too. A late-payment upcharge policy often goes a long way toward discouraging payment delays, as does a small early-payment discount.
Split fees for faster collection. If there are any parts of your invoice that are likely to be disputed — such as fees or expense reimbursement — bill those items separately from the product or service deliverables. Even if your customer takes a long time to review and approve those charges, they won’t have an excuse to delay reimbursing you for goods and services you’ve already delivered.
Optimize inventory. You don’t want your cash tied up in stacks upon stacks of boxed merchandise languishing in your warehouse. On the other hand, too little on-hand inventory could mean lost sales. The trick is to keep a finger on the pulse of demand, align roles and responsibilities, and identify processes that can be streamlined. Stay closely attuned to what your company’s marketing team has coming up and plan to have plenty of stock on hand before the next big ad blitz. Set up sales and operations planning and forecasting schedules. And tap into all available data sources to obtain credible demand data, and track trends in customer perceptions of your product and your competitors.
Get lean. Lean companies work through their finished goods inventory, deliver flexibly, and ship faster. Inventory can be quickly liquidated and turned into cash. A thorough mapping study of end-to-end processes, fixing gaps wherever they are found, can help you push your operations to be as lean as they can be. You can also partner with both internal and external suppliers to integrate processes and make replenishment as fast and efficient as possible. But no matter how lean you go, always remember to include safety stock calculations, as stock-outs and backorders can damage customer service and your company’s reputation.
Strike the right balance of raw materials. Materials shipped overseas must arrive in time for your company to fulfill orders without incurring hefty emergency shipping charges. While materials sourced globally may cost less because of cheaper labor, many companies are now “onshoring” some of their raw materials purchases, weighing the additional cost against the convenience and flexibility of a shorter supply chain and less inventory to carry.
Break down and fix your order-to-cash process. Take a hard look at every step of your invoice process, and eliminate redundant or unnecessary steps that might slow down the payment cycle. Whenever possible, use digital invoicing and payment to take extra time out of the process.
As with any improvement initiative, you won’t know where to start unless you know where you already stand. The first step to improving your current cash-to-cash cycle time is to calculate, on average, exactly how long it’s taking your company to recoup its investment in its products and services. If it’s anywhere longer than 30 days, you may have an opportunity to improve your company’s cash flow.
Marisa Brown is the senior principal research lead for supply chain management and financial management at APQC, a non-profit benchmarking organization based in Houston.