Your Cash Conversion Cycle - The Easy Formula for Your Business Success

Welcome back! I want to continue building from last month’s newsletter and further explain the Cash Conversion Cycle for your business.

These two editions of the newsletter (May and June) will help you better understand your historical borrowing needs. From here, we will explore your “borrowing base” in the July newsletter.

I went back and made some additions to the FREE excel sheet, available here. I’ll explain these changes below, but first let’s get some definitions out of the way.

What is the Cash Conversion Cycle

The Cash Conversion Cycle (CCC) is a calculation used to express the amount of time it takes your business to convert money invested into money generated. The CCC will show you how long money is “tied up” within the normal operations of your business before it is reclaimed (ideally with growth) at the end of your business cycle. Below is a simple diagram. Starting with “Cash”, one trip around the circle equals one cash conversion cycle.

The Formula

The calculation for your CCC is straight forward.

CCC = DIO + DSO – DPO

DIO = Days of Inventory Outstanding

DSO = Days Sales Outstanding

DPO = Days Payables Outstanding

Days Inventory Outstanding

Where:

Avg. Inventory = ? x (BI + EI)

BI = Beginning Inventory

EI = Ending Inventory

COGS = Cost of Goods Sold

Days Sales Outstanding

Where:

Avg. Accounts Receivable = ? x (BAR + EAR)

BAR = Beginning AR

EAR = Ending AR

Days Payables Outstanding

Where:

Avg. Accounts Payable = ? x (BAP + EAP)

BAP = Beginning AP

EAP = Ending AP

COGS = Cost of Goods Sold

One key item to remember with all these calculations, they need to all be completed based on data from the same period. Meaning if you only want to look at one Quarter of the year, then you need to adjust the equations to represent this amount of time, and each data point must only come from those quarters.

Again, I have updated our previous spreadsheet to now include these calculations for you, shown below. This FREE Excel sheet can be found here!

About Your CCC score

Your CCC score is constantly evolving. A lower score is desired, as that means your business is running more efficiently. The key is to track this number over several years to look for trends and patterns. Also, you need to understand your industry. Many companies don’t have inventory, so their equation will be much different compared to a business that will carry large amounts of inventory. Also, a company could easily have a negative CCC value, which could actually equate to a positive source of cash for their operating cycle.

Using your CCC to determine your Line Of Credit Request

The goal of this newsletter is to equip you with the knowledge to successfully work with your bank to find the best solution to meet your needs. You will be in a much stronger position if you are able to understand what the bank will look for, and use that knowledge to make an informed decision when you approach them with a request.

When it comes to a Line of Credit, you don’t want to ask for too little of an amount. If you are just taking a guess as to how much you need, then you can easily find yourself in a cash crunch later on. Also, you won’t want to ask for too much, as the bank could deny the request all together. However, if you come in with an informed approach, you and the bank will be more likely to find a great solution that fully meets your needs without the bank over extending their credit offering. ?

Remember, the bank is setting aside the money for your line of credit. This money is pulled from their deposit base (which they are paying interest on to the deposit holders). If the money just “sits” there and isn’t used, then the bank could be losing money on the transaction. From a banks point-of-view, they want a customer that fully/highly uses their line, but also pays it down to $0 at least once a year. And remember, Lines of Credit are typically only good for one year, meaning the bank will re-evaluate your business every year. Lack of line usage could result in them “exiting” you as a client, or them only offering a smaller line to better match your usage, not necessarily your needs.

Use the following formula to determine your borrowing needs based on your CCC calculation.

Next Steps

The tools and equations listed above are meant to help you with your decision-making process. One key item to remember, all of these metrics are looking at the past. You will also want to consider future growth and expansions in your credit request. It could be worth you checking out an older article I wrote on the benefits of using debt to fuel your business growth - found here.

Now that we better understand your borrowing needs, the next articles will explore your borrowing base. This is the collateral source used by the bank to secure/guarantee your loan. Tune in next month!