"Evaporating” your Cash Constraint

Has your cash and liquidity declined so far as to put your company in danger? What can you do to get out of this mess?

By Ravi Gilani, Eli Schragenheim, Rudolf Burkhard

Too little cash demonstrates how important enough money is for survival. Companies that suffer a brush with bankruptcy understand the danger well. They feel the danger and the need for drastic measures!

Cash constraints threaten a company’s survival. Quick action to emerge from this distressing situation is essential. Significant corrective action becomes imperative. Business practices, policies and behaviours must change. Owners, employees, and customers expect management to act!

Too little cash disturbs buying necessary materials and components. To conserve cash buyers, buy smaller quantities which raises questions in suppliers’ minds. Internally a lack of cash causes under-utilisation and disrupts the flow of money – profit declines. Revenue, to buy more materials is not earned. The lack of cash worsens. The company enters a vicious cycle. It must get out.

A cash ‘crunch’ makes cash the goal. Cash becomes everyone’s focus. Focus helps the company stay in business. It also makes management behave differently. They will do ‘anything’ to secure more cash. A threat to a company’s existence causes top management to focus on paying suppliers more slowly and on getting paid quickly.

A cash constraint's threat to a company's existence increases TOC's importance. Your decision on how to deal with the cash constraint is key. It is critical to subordinate everything else to your decision. All resources should act to ensure the success of your decision. The organisation works as a team to solve the cash crisis.

We show ways to ‘elevate’ the constraint to get more cash, fast. Speed is critical as no company with a cash constraint can survive for long. We know it is often possible to re-establish a normal cash position within 15 – 20 weeks.

You need to understand two key parameters to get out of a cash bind. They help understand the likelihood of your success. Customers, suppliers, banks, and investors will want to know the values.

The parameters are “cash-to-cash cycle time” and “cash velocity”. They will help you understand how to speed up ‘cash velocity’. They help take the correct actions even if these are counterintuitive. Do the right thing for these parameters even if it means sacrificing some other key performance indicators. Whenever Cash is King other indicators become “unimportant”.

Cash to cash cycle time is the total time from cash going out to cash coming in. Cash out is the moment you pay for materials. Cash in is the time your customer pays for the product he bought. Cycle time is the time between cash out and cash in.

(The more inventory in your system, the longer your cash cycle time. Inventory is in your system from the moment your company pays for materials. It is cash out until your client pays. The inventory you do not need yet consumes cash until it is paid for by a client. Nota Bene: When a client buys, his payment is not yet in your bank account – it is still "in" your inventory.)

The red arrow in the graphic shows the cash-to-cash cycle time. The days of supply in inventory plus the days it takes customers to pay is your cash cycle time. Shorter cycle times are better.

Cash Velocity is the rate at which your business generates cash. What is the rate of cash generation per week from a 1€ investment? Assume the cash-to-cash cycle time is 3 weeks. At the end of 3 weeks, the company gets 2€ from customers. What is the cash generation rate per week? What is the cash velocity?

Cash Velocity (CV) is thus (1.26-1) €/week= .26 €/week from a starting investment of 1€. It is the weekly cash contribution.

The cash generated per week (the cash velocity), is the rate of cash generation. Cash flows into the company only after completing the cash-to-cash cycle time … here after 3 weeks. The higher the Cash Velocity the better!

Companies finances fixed costs (mainly salaries and wages) and investment in materials and components. To solve your cash constraint, convert materials and components into cash faster. Solve your cash constraint you will have a new constraint elsewhere! (The 1€ we invested in the cash velocity discussion above is for materials and components).

Another useful parameter is the contribution ratio CR

The higher the contribution ratio, the better!

Here is the formal equation for Cash Velocity (CV).

The n is the number of periods in the cash cycle time. What follows is the equation using the numbers above (In the generic equation for CV n is the nth root S/TVC)

Too many equations? Your key focus areas are:

As short as possible a Cash Cycle Time, and …

A high Cash Contribution Rate

Below are the details for calculations using Goldratt’s P-Q thought experiment. The link is to my article about the experiment where I ask how much money you expect can be made using standard costing. Then answer, how much money can this small factory by using constraint thinking? Here I added the different lead times to show that the right product to sell can be different in a cash crisis.

First, solve the thought experiment to conclude which product to prefer. It is the one that uses the constraint (the experiment's constraint) better. The decision parameter is Throughput per Constraint Hour (Gross margin per Constraint Hour). This is correct for the thought experiment because cash is not a problem. But is it still true if we do have a cash problem?

Table 1 shows that Q has a much better Cash Velocity per week than P. Because Q customers pay much sooner. You might favour Q product sales because you get cash back faster. (Both answers – when cash is or is not the constraint – are not intuitive to most of us. Our education gets in our way).

The P-Q thought experiment discussion is here. The article does not consider cash: https://www.dhirubhai.net/pulse/impact-more-than-one-constraint-rudi-burkhard/

You have two critical objectives with a cash constraint:

Ensure cash to pay fixed costs; the payments you make to keep the system running. This is your Operating Expense (OE).

You must have enough cash for materials and components essential for sales. These are your Variable Cost (VC).

To survive your company needs n*OEperiod of cash and the cash to buy materials and components for production. You must produce and sell enough to maintain or increase your starting cash level. Without this, your company fails. The ikey question is, “How much cash is enough for survival?” You need to know that after n periods your company will still have the same amount (or more) of cash. This cash is the “adequate for survival cash (ASC)”.

1. You need the cash to pay fixed costs (depreciation is not a cash cost). You need to be able to pay n periods of Fixed Costs or Operating Expenses. You need n*OEperiod of cash. Enough cash to cover the period between cash out and cash in.
2. (ASC-n*OE) is the cash available to buy materials and components for production.
3. After n periods our (ASC-n*OE) investment in materials and components must yield at least ASC of cash.
4. The contribution rate (CR) must generate at least ASC from (ASC-n*OE) investment in materials and components after the n periods of our cash cycle time.

Enough cash must cover the n periods of the cash-to-cash cycle time. And have at least the same amount of cash you start with. This situation is like "treading water" … the situation does not get worse, but it also does not get better.

What we want is enough cash to pay n*OE plus enough to run our factory at capacity. We call this amount “Sufficient Cash Requirement " (SCR). We assume here that 1000 more cash per period is enough to keep our factory running at (close to) capacity. There is an important proviso here – we must be able to sell the products we will produce!

The table to the right shows how we arrive at SCR for the P - Q example. The table shows that Q is the better option to pursue to solve the cash constraint problem. This is the opposite conclusion from that of the standard P-Q thought experiment.

?Demand for Q may limit how much the organisation should invest in Q materials. If there is no bottleneck, the company can invest in P materials. Selling more P improves the cash situation.

Reality will be messier. There will be orders in the pipeline … cash in and out does not start as we did with our example. It’s an ongoing cash-out and cash-in process. Still, the principles apply.

What we want is enough cash to pay n*OEperiod plus enough to run our factory at capacity. This amount of cash is the “Sufficient Cash Requirement " (SCR). In the table, we assume that 1000 more cash per period is enough to keep our factory running at (close to) capacity. There is an important proviso – we must be able to sell the products we produce!

The table shows how we arrive at SCR for the P - Q example. The Figure 2 shows Q is the better option to solve the cash problem. This is opposite to the standard P-Q solution.

Demand for Q may limit how much the organisation should invest in Q materials. If there is no bottleneck, the company can invest in P materials. Selling more P improves the cash situation.

Reality is messier. Orders will be in the pipeline … cash in and out does not flow as in our example. We are dealing with an ongoing cash-out and cash-in process. The principles still apply.

To ease the situation, negotiate with suppliers and customers. They want to see how your company will get out of the cash mess. They will want to see the various parameters we defined above.

The company will not have the ability to take decisions in isolation. Focusing on selling Q products is unlikely to work 100%. Some customers may need both P&Qs.

The process to get out of a cash constraint situation

You focus on generating as much cash as fast as possible through the effective use of existing cash. A small increase or reduction in cash can make or break the organization. It is often possible to come out of a cash problem in less than three months. Do it by reducing cash to cash time, to accelerate cash velocity.

Shrinking cash to cash cycle time (n) improves Throughput. Cash availability gets better. Survival time gets longer. Often shrinking cash to cash cycle time is good enough to come out of the cash constraint situation.

The TOC techniques to speed up the flow of value to customers shorten the cash-to-cash cycle. Choke order release and use buffer management to shorten the cash-to-cash cycle. If you have not yet implemented choke the release and buffer management, do so as soon as possible. By these 2 actions, you insulate your company from a cash constraint. It at least delays the cash constraint.

More ways to reduce the cash-to-cash cycle time are:

Reduce the time it takes customers to pay. A price reduction for faster payment is paramount for higher cash velocity. You can show that a 20% discount for payment within 1 week instead of 4 can exploit the cash constraint better. This might (is) not the right move if cash is not the active constraint.

Shorter manufacturing lead times have a significant impact. It is always good to reduce manufacturing lead times. The impact of a shorter lead time when you are cash constrained is even more critical. Check anything that can reduce production lead time and cash cycle time should. Anything might be to use overtime and other not-so-obvious actions. Check!

The five focusing steps of TOC are key to finding ways to deal with a cash constraint. They help you minimise the devastating impact of a cash constraint. Remember the purpose is to get rid of the cash constraint. Cash is not a resource to keep as a system constraint!

As a manager, you should take action to immunise your company from a cash constraint. Less work in process requires less cash and speeds up cycle times. Dynamic Inventory Management (DIM) reduces the cash needed to finance inventory. An excellent continual improvement (POOGI) process shortens cycle times further. That allows you to further shrink stock levels without compromising customer service.