ArchivesCash Flow Archives — C. Lynn Northrup, CPA, CPIM

Cash Conversion Efficiency

December 29th, 2008

In these times, cash is king. Achieving better cash flow starts with sales and marketing. A tough economic environment means there are more businesses looking for the same customer. Taking a more aggressive approach to finding more sales leads that can be converted into sales is a critical component to increasing your cash flow. You might even have to shave the selling price to secure the sales, so knowing your profit margins is essential.

Once we secure the sales it is time to be firm on how and when you will get paid. This is one of the key areas where cash conversion efficiency begins. Get cash at the time of sale if possible. Most businesses sell on credit, typically with terms of payment in 30 days. The days accounts receivable are outstanding is one of components of the cash conversion efficiency ratio. The faster or fewer number of days sales outstanding, the better. This generates cash needed for the business.

You have to purchase materials or goods that are recorded in inventory before converting them into sales. Since you likely paid for these goods based on credit of 30 days net and perhaps a discount of 1 to 2 percent if paid sooner than the terms of credit. The more effectively you turn your inventory into sales by reducing cycle time is crucial. Likewise, use your vendors as a bank by adhering closely to the established terms of sale without losing the discount offered.

Your cash conversion is determined by combining the average number of days cash is tied up in accounts receivable plus the average number days cash is held in inventory less the average number of days of payables. The smaller the number of days contained in the cycle the better.

Some additional metrics that should be monitored include:
• Cash as a % of Sales
• Gross Margin %
• Selling, General, and Administrative Expense as a % of Sales
• Net Working Capital as a % of Sales

The faster your cycle time, the faster you will convert your sales into cash. A component in achieving faster cycle times is to reduce the number of days required to send out your sales invoices after goods have been shipped or services rendered.

A couple of good references on how cash conversion efficiency is used include Go with the Flow published on CFO.com and Cash Conversion Efficiency – A Great Outcome published by Management Mythbusters.

Focusing on these basics of accelerating cash flow will help keep your business healthy in these turbulent economic times.