Tracking the Cash Cycle

In a previous Blog (It’s Cash That Counts) we spoke about the need for keeping track of Working Capital, the cash that you need to keep your business operating. We also spoke about the importance of the timing of cash flows and presented a formula for calculating Working Capital. In this posting, I would like to unpack that calculation and talk about some of the elements that go in to it: Inventory Days, Receivable Days and Payable Days and how they relate to keeping your business successful.

While having a “Net Profit” at the end of the month is desirable, the bottom line on an income and expense statement is for accounting purposes and it does not take into account the timing of income and expenses in your business. A Capital Balance sheet will help, as it shows the amount of Working Capital that your business requires over the period calculated. Underlying Working Capital is the Cash Cycle (sometimes called Trade Cycle) that determines Working Capital. Reviewing Cash Cycle components can be an important exercise to understanding how your business is doing.

Inventory Days. The formula for Inventory Days is:

Average Inventory = (Beginning Inventory + Ending Inventory) /2
Divided by
Daily Cost of Sales = ((Beginning Cost of Sales + Ending Cost of Sales ) /2) /365

The result of the calculation will tell you the number of days of Inventory that you have on hand. Here is an example:

Average Inventory = ($200,000 + 300000)/2 = $250,000
Divided by
Daily COS = (($750,000 + 1,000,000)/2)/365 = $2,397
= 104 Inventory Days

From the calculation, we can see that the company keeps 104 days worth of inventory on hand. One way of knowing whether that is good or bad is to compare 104 to the industry average. If, for example, the industry average was half that, say 50 days, then you know that it would be difficult to be competitive without lowering the amount of inventory on hand.

Receivable Days. The formula for Receivable Days is:

Average Accounts Receivable = (Beginning Receivables + Ending Receivables)/2
Divided by
Daily Sales = ((Beginning Sales + Ending Sales ) /2) /365

The result will give you the average number of days that it takes your company to collect a dollar of receivables. Here is an example:

Average A/R = ($550,000+ $350,000)/2 = $450,000
Divided by
Daily Sales = (($1,500,000+ $1,300,000) /2) /365 = $3,835
= 117 Receivable Days

Payable Days. The formula for Payable Days is:

Average Accounts Payable = (Beginning Payables + Ending Payables)/2
Divided by
Daily Sales = ((Beginning Sales + Ending Sales ) /2) /365

The result will give you the average number of days that it takes your company to pay a dollar of payables. Here is an example:

Average A/P = ($250,000+ $150,000)/2 = $200,000
Divided by
Daily Sales = (($1,500,000+ $1,300,000) /2) /365 = $3,835
= 52 Payable Days

The Final Formula for the cash cycle is then:

Cash Cycle = 104 + 117 – 52 = 169 Days

In other words, it takes 169 days for $1 utilized in the business to be collected back into the business.

The real key is to interpret this number against the company’s result. There are two questions: first, is the company “cash poor”; always having trouble making a payroll or paying bills? If so, the key is to find ways to shorten the cash cycle, such as negotiating shorter payment periods with customers or longer payment periods with vendors. You could also work at decreasing the amount of inventory kept.

The second question is how well do these numbers compare with the industry in which they compete. If the cash cycle is significantly higher than the industry average, the company will likely have trouble being competitive. If the number is about the same or lower than the industry average, they should be competitive.

Two last notes: all of these calculations have been done on an annual basis. You could also calculate them on a quarterly or monthly average. Simply adjust the calculations to suit your time period. Also, if your company does not inventory, then simply remove inventory from the calculation.

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