In New Zealand, small and medium-sized enterprises account for 97 per cent of all businesses. Their earnings comprise 25 per cent of the nation's GDP, and Kiwi SMEs are responsible for 28 per cent of the country’s employment. In short, SMEs are vital to the economy, and entrepreneurs running them need all the help they can get to ensure their businesses survive and do well in this increasingly challenging economic environment.
If you’re part of this sector, one way to realise your business goals is to ensure that you have an understanding of the basic accounting principles that have a massive impact on your business. The technical know-how, as well as in-depth financial matters, should be handled by your accountants. Dunedin entrepreneurs like yourself, however, should still be knowledgeable of accounting best practices and have an inkling about how these factor into the best financial decisions for your business.
On that topic, cash flow, or the movement of money going in and out of the business, is often seen as an overall indicator of its financial health. But behind the scenes, a solid metric called the cash conversion cycle (CCC) will show a more detailed picture of when investments are converted into money that your business actually earns. To illustrate, here’s a briefer on everything a Kiwi SME owner needs to know about the CCC.
What Is the Cash Conversion Cycle (CCC) All About?
At its core, the Cash Conversion Cycle (CCC) is a financial metric that measures the time it takes for your company to convert its investments in inventory and other resources into cash flows from sales. In simpler terms, it encompasses the journey from spending cash to receiving cash.
For instance, if your business involves manufacturing clothes, the CCC will be the time period or the days from when you bought fabric and thread to the time that you got paid by the retail outlets you supply. The lower the CCC is, the better it is for your business since this indicates a faster turnover.
This cycle comprises three key components, namely the days inventory outstanding (DIO), days sales outstanding (DSO), and days payables outstanding (DPO).
To compute for your CCC, you’ll need the DIO, DSO, and DPO values. The formula can be expressed as:
CCC = DIO + DSO − DPO
The days inventory outstanding (DIO) represents the average number of days it takes for your company to sell its inventory. A lower DIO means a faster inventory turnover. The formula for the DIO is as follows:
DIO = (Average Inventory / Cost of Goods Sold) x 365 days
where:
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
Cost of Goods Sold = (Beginning Inventory + Purchases During the Period) —
Ending Inventory
Meanwhile, the days sales outstanding (DSO) measures the average number of days it takes for your company to collect payment after making a sale. This time, a lower DSO suggests faster cash collection. For the DSO, here’s the formula:
DSO = Average Accounts Receivable / Revenue Per Day
where:
Average Accounts Receivable (AR) = (Beginning AR + Ending AR) / 2
The last metric you need is days payables outstanding (DPO). This indicates the average number of days it takes for a company to pay its suppliers. If you get a high number of days, it means it takes longer for your business to pay your suppliers.
DPO = Average Accounts Payable / Cost of Goods Sold
where:
Average Accounts Payable (AP) = Beginning AP + Ending AP
How Does the CCC Impact Your Business?
The CCC has a profound impact on your business. It influences everything from the health of your cash flow to your operational efficiency. In general, you’ll want a lower CCC, which means a shorter span of time that cash is tied up in the business cycle. This allows you to achieve more agile and efficient business operations, with faster decision-making and more financial leeway in case of sudden opportunities or emergencies.
The best-case scenario for any business is a negative CCC, which means that your inventory is sold before you even have to pay for it. This is the reason companies spend so much effort offering items like smartphones, new tech gadgets, and condominium units in preselling campaigns.
As an entrepreneur, you can monitor and optimise your business’s CCC to eliminate inefficiencies or bottlenecks in your business. Moreover, you can implement strategies recommended by your accountant or your finance team to improve productivity and reduce costs. This will not only enhance your bottom line but also strengthen your company's competitive position in the market.
How Can Entrepreneurs Optimise their Cash Conversion Cycle (CCC)?
Optimising the CCC requires a strategic approach and a focus on continuous improvement. Below are a few starting strategies to streamline your business’s CCC and enhance your financial performance:
1. Streamline Your Inventory Management
Upon analysing your customer buying behaviour, supply chain, and other information, you can derive insight into your business’s demand patterns, implement just-in-time practices for it, and negotiate more favourable terms with suppliers to reduce your inventory holding costs and improve your inventory turnover.
2. Consolidate and Make Incentives Part of Your Accounts Receivable Management
Offer your clients incentives for early payments and streamline your invoicing processes. You should also closely monitor any ARs that are ageing to accelerate your cash collection.
3. Negotiate Better Accounts Payable Terms
Allow for improved financial flexibility by negotiating longer payment terms with your suppliers. Alternatively, you can take advantage of early payment discounts and work to optimise your payment scheduling to maximise your available cash.
4. Improve Supply Chain Efficiency
Lastly, to improve your supply chain operation, it’s not enough to rely on sound data analytics. You also need to work on building strong relationships with your suppliers. In addition, you can implement lean principles for your business, such as eliminating waste and leveraging new automation solutions that can increase your efficiency and cut costs.
Accounting experts like the people at Target Accounting can help you review your financial situation and make sure that you’re on the mark when it comes to optimising your CCC. Contact Target Accounting today to master this vital metric and ensure the profitability of your enterprise at any given time.