The hardest part of operational finance is convincing people to turn prefactual concepts into today’s actions.
When we spend more on ads, we immediately see an increase in sales. When we reduce OpEx, we can intuit that next month we will have higher profits. We have seen those patterns before. We can measure the ad spend and resultant sales in Shopify. The time between action and result is short.
But when we place a PO for less inventory because we ordered smarter, we don’t wake up the next day to more cash in the bank account. The resulting benefits of reducing Days Inventory Outstanding become murkier because the prefactual - the difference between what would have been and what will be - is complicated my multiple steps in the cycle and time.
The simplest prefactual is ad spend to sales. The hardest of the prefactuals is increasing Free Cash Flow through the reduction in Cash Conversion Cycles.
Think about the leap in human development from hunter gatherers to agrarians.
Ad spend to sales is the hunter.
‘Me throw spear. Me eat dinner.’
Increasing Free Cash Flow is the agrarian.
‘Hey everyone, if we spend all our time doing back breaking work of cutting down trees and clearing rocks and then get together to build an irrigation ditch from that river, we can all eat a lot more sometime next year because trust me, I did the math. Now whose with me!?’
Harsh on our marketing friends, but you get the point. There is nothing more important to a business than generating cash. So the purpose of this post is to provide the why and how so you can convince your colleagues of the value of taking actions today to improve cash in the future.
First, let’s convert theory into some hard cash numbers.
Each day of reduction in Days Inventory Outstanding equals one day of COGS more cash.
Each day of reduction in Days Sales Outstanding equals one day of Net sales more cash.
Each day of increase in Days Payables Outstanding equals one day of COGS more cash.
Now, we can step through why the above is true.
Your Cash Conversion Cycle is the number of days it take your business to turn cash invested in inventory back into cash from selling your products.
It answers the question of how long does it take for a dollar invested in inventory to turn back into a dollar in my bank account?
It’s measured in days and the formula combines three measures:
CCC = DIO + DSO - DPO
Written out this is:
Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding - Days Payables Outstanding or
The number of days it will take me to sell my inventory
PLUS
The number of days it will take me to collect cash from my customers
MINUS
The number of days I take to pay my vendors
To answer our question of the value of reducing CCC by one day, we need to go one level deeper into the components. Unsurprisingly, there are variations on how DIO, DSO and DPO are calculated, but the following is what I find most intuitive and easiest to follow for others.
DIO (Days Inventory Outstanding) is telling us the number of days it will take us to sell our inventory. To understand the inventory number, I prefer to use the average inventory. So we do
(Inventory Value Beginning of Period + Inventory Value End of Period) / 2 = Average Inventory
To understand the time to sell through, we calc our average COGS per day over the period.
Total COGS over period (i.e. month or quarter) / number of days in period = Average COGS per Day.
DIO is then Average Inventory / COGS per Day = the number of days it takes to sell our inventory.
DSO (Days Sales Outstanding) is telling us how long it takes to receive our cash from customers once we have sold our products. For a pure DTC brand, DSO is basically the time between when you make a sale and Shopify puts the money in your bank account. But for brands with a wholesale channel, collections can stretch to 90 days or longer depending on your retail partners and your AR collection capabilities. To figure out DSO we take:
(AR Beginning of Period + AR End of Period) / 2 = Average AR and
Net Sales in Period / number of days in Period = Net Sales per Day. This is your total Net Sales not just your Net Sales to Wholesale because you are trying to figure out the CCC for your company as a whole, not just a part of it.
DSO is then Average AR / Net Sales per Day
DPO (Days Payables Outstanding) is telling us how many days it takes us to pay our bills. We take:
(AP Beginning of Period + AP End of Period) / 2 = Average AP and divide it by COGS per day (see above) so
DPO is then Average AP / COGS per day
You will see variations on these formulas e.g. people using ending or beginning balances as opposed to averages or different ways to get to daily numbers, but the point is to choose one methodology and use it consistently. I like the method above because it seems the most intuitive to me.
Now that the formulas are out of the way, let’s get to the good stuff - convincing everyone of the value of reducing CCC.
Assuming sales stays the same, then
Each day reduction in DIO eventually equals one day of COGS of cash.
Each day reduction in DSO eventually equals one day of net sales of cash.
Each day increase in DPO eventually equals one day of COGS of cash.
To make this tangible, all we need is the following.
To get marketing excited, we do this:
As discussed here, improvements in your business compound. So what does this improvement in your CCC do for you over time?
And if you are an owner who wants to distribute cash…
Here’s the simple model I am using in the above examples (see the tab Simple Value of a Day of CCC)
I hope this helps you motivate your teams to reduce your Cash Conversion Cycle and generate more cash! Let me know your feedback and questions.
I help brand leaders make more money through better finance. If that sounds useful, let’s chat!
