Being able to work out your cash flow is a key task that all business owners should be able to do. The up and down nature of revenue within many small businesses necessitates the planning of cash flow. Seasonal factors and one off large orders can easily give an unbalanced perception of the cash flow of the business.
Consequently on different occasions it may be hard to effectively manage cash flow solely via income and expenditure methodology. An alternative method which can be used is the conversion cycle method. The conversion cycle method involves calculating the length of time that is taken to convert activities into cash. That is the length of time taken to recoup the money spent to finance activities or services as a cash return.
Why should I be concerned with the cash conversion cycle?
There are three elements of working capital that make up the cash conversion cycle (CCC):-
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Accounts Receivable Outstanding in days (ARO)
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Accounts Payable Outstanding in days (APO)
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Inventory in Outstanding Days
CCC = IOD + ARO – APO the final number of days represents the number of days that the businesses cash remains actively tied up operationally within the business. The lower the number of days the more healthy a business is. A higher number of days represent a warning sign that the business is heading towards difficulty. Analysing theses results over a period of time will help to identify any trends that require attention. It will also give a better representation of what the cash flow of the business is.
Understanding the different components of the cycle
It is not too difficult to understand factors affecting cash flow such as decreases or increases in profit margins. What is a little more difficult to understand is the working components of the CCC. A shorter period of collection provides an increase of cash coming into the business. Any decisions in regards to prolonging payment over an extended number of days will result in less money within the business. Knowing how many days you need to budget for gives a better indication of the kind of cash flow that is required by the business.
Correct implementation and management of the conversion cycle can have a positive impact on the business’s cash flow and profitability. The management of your cash conversion cycle could help the business to determine whether or not additional lending is required or whether not the business is able to meet its financial obligations.
Benefits of using the benefits of using the cycle
An additional benefit of using this particular methodology is that it also offers insight into the infra structure of the business. It offers an additional perception into the cost attached to each particular service or product. Hence you may need to decide which products to expand on or which products require price revisions or even discontinuing. Either way you will be able to make informed decisions about the running and sustainability of your business.
