How to ensure sustainable cash flow improvements?

Liquid cash is the most significant factor for growth in any organization and many companies continue to make improvements to managing their overall working capital. 

But when monitored properly and closely, sometimes the working capital performance is not as exemplary as their balance sheets reflect. This unreal progress can make companies continue living in a dream bubble and probably make them take wrong decisions.

Why is cash flow sustainability required in a business?

Small Business owners choose to make it a priority most often because of the following reasons:

  1. It increases business value.
  2. It aids in mitigating potential risks.
  3. It aids in the prediction of future earnings
  4. It provides greater security to your family and your employees’ families.

Cash Conversion Cycle (CCC) is something that ensures a healthy working capital and is followed religiously by the investor community. CCC is a measure of the networking capital metric and it signifies how fast a company can convert cash in hand into inventory and accounts payable, through sales and accounts receivable, and then back into cash. The formula for the same is:

CCC = DSO (Days Sales Outstanding) + DIO (Days Inventory Outstanding) – DPO (Days Payables Outstanding)

The cash cycle equals the number of days required to sell your inventory (DIO) minus the number of days required to pay to the vendors (DPO) plus the days you need to collect pending invoices amount (DSO).

DIO: Days Inventory Outstanding

  • The number of days on average that your company turns your inventory into sales.
  • The smaller this number, the better

    DPO: Days Payable Outstanding

  • The number of days it takes you to pay your accounts payable.
  • The higher this number, the longer you can hold onto cash, so a longer DPO is better

DSO: Days Sales Outstanding

  • The number of days you’ll need to collect on the sales of that inventory after the sale has been made
  • Similarly, lower the number, the better.

Let’s understand this better through an example below:

Shubhi runs a company on industrial supply and has a good record of paying her suppliers within 30 days. She keeps enough inventories in hand to fulfill 60 days of sales and is good at managing this. It will take 52 days on average for her customers to pay their invoices. This would be her CCC formula:

CCC = 60 days – 30 days + 52 days
CCC = 82 days

Shubhi will need on average 82 days of working capital to convert purchased inventory into cash.

This was a simplified example and make sure to include DIO, DPO and DSO on monthly, quarterly and annually for tracking.

This is a simplified example, and to get the most accurate results you should track your DIO, DPO, and DSO on a monthly, quarterly or annual basis, along with the dollar values for inventory and sales.

What are the signs of actually sustainable cash flows?

Most of the entrepreneurs have this impression that why do they worry about cash when there seems to be so much of it on their balance sheets?
First, with sales in the global economy relatively healthy and the cash to pay receivables plentiful, an improvement over a very mediocre performance in 2015 was almost expected. And despite the downtick in days, the CCC in 2016 was still relatively high. It was at nearly the same level in the depths of the Great Recession when banks pulled company credit lines and businesses put off payments to suppliers in order to stay liquid.
2) Another reason is that the overall CCC improvement invites skepticism regarding trends in the components of working capital — DSO, DPO, and DIO — are actually upsetting. There is a long-term improvement in DPO, degradation in DSO performance and a slight deterioration in DIO.
In fact, the improvement in cash flows can be attributed to a relatively healthy global economy that is driven largely by an improvement in DPO – stretching payments to vendors.

Data points to understand
While trying to understand your true cash flow, there are several data points within the cash conversion cycle that financial executives should follow closely:
Days Sales Outstanding

  • Monitor/report deviations from credit policies – e.g. ‘no shipments to customers with balances greater than 90 days past due.’
  • Identify patterns of customer acceptance times to actual payment dates,
  • Correlate > 90-day customers to Return Material Authorization history to identify product quality issues. 
  • Track customer disputes for incorrect invoices and related processing delays.

Days Inventory Outstanding

  • Monitor/report differences in actual stocking levels compared to target levels
  • Track vendor delivery performance and incoming quality
  • Correlate manufacturing efficiency to stocking levels
  • Track actual unit shipments to the sales forecast

Days Payable Outstanding

  • Monitor deviations from preferred vendors/ terms
  • Track payment terms for critical suppliers 
  • Track vendor usage of supplier financing or offering prompt pay discounts
  • Correlate customer payment trends to align vendor payments – e.g. pass on the delay

Conclusion and key takeaways
Tracking performance and monitoring policies are keys to improving operational results and cash flow. Unfortunately, most organizations have multiple applications to deal with critical transactions for everything from inventory, manufacturing, sales, and human resources to finance supply chain and more. Managing performance within a single application can be challenging enough. Imagine the scale and complexity across dozens of enterprise applications with thousands of users and multiple lines of business.

Real-time tracking and monitoring bring tremendous benefits to virtually every enterprise. By ensuring that policies are implemented and followed and that internal and vendor performance issues are quickly identified and addressed, businesses can confidently project and improve cash from operations as well as other financial and operational results.

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