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Sound cash management ‘cheapest investor you’ll ever find’

(Editor’s note: This column is part of a continuing series related to the financial challenges of accelerated growth, and in this case, highlights the value of cash and working capital management.)



“An optimist sees an opportunity in every calamity, a pessimist sees a calamity in every opportunity.”                – Frank Lloyd Wright



John Wilson, CEO of Ace Business Stuff, was pondering a dilemma. He had recently revised his sales program following his conversation with Lary Columnist, but was grappling with its cash-flow challenges.

John clearly saw the advantages of projecting their expected performance so they could evaluate the potential outcomes before they occurred. At the same time, he was frustrated that he seemed to have little control over his balance sheet, and continued to struggle with how his profitability could be growing while his cash was shrinking.

He didn’t really understand why the bank cared so much about working capital, inventory and accounts receivable/accounts payable balances, and with the bank meeting coming up, he feared their story wasn’t solid enough.

 “John,” I said, “I understand your frustration with your balance sheet, so let’s talk about the sales cycle first.

“When we talk about the sales cycle, or what some call the operating or cash cycle, we’re talking about seeing that process from a different perspective. You can use the same data to evaluate how efficiently you’re managing your working-capital assets, or to evaluate the cash impact of your activities. In essence, this approach examines how long it takes for you to convert inventory into cash by measuring the days outstanding in accounts payable (AP) and accounts receivable (AR) as well as inventory turnover.

“I’ve prepared a simple example that I’ve projected up on the board. Keep in mind, John, that working capital is closely examined by bankers because it reflects where your cash is invested and how long it takes to actually generate cash. We’ve talked previously about the lack of cash in the face of increasing profitability. If you think about it, the reason you don’t have the cash – yet – is because you have invested it in inventory or AR.”

“It’s not like I have a big choice, Lary. I can’t live without inventory and I have to extend terms to my customers. I don’t see how that’s my fault.”

“Of course you have to do those things, John. But how well you do them – manage your inventory and collect your AR – has a lot to do with where your cash is. Let me show you.”

 “On the board you can see the key assumptions we’ll use, most of which approximate your actual balance sheet. I’ve also shown the basic definitions used to measure operating efficiencies, or the cash collection cycle. In each case, we’ll assess the inventory, AR and AP outstanding by averaging the beginning and ending balances for the year. In the Days Sales Outstanding (DSO) calculation, in the ‘Now’ column, I’ve calculated your average sales per day to be $27.4K over the entire year. When you divide that into your average AR of $1.65 million, you can see that it represents about 60 days worth of sales, meaning it takes you about 60 days to collect your AR.”

“How can that be if our terms are N/30?”

“It could be several reasons, John, which Tom will know more about. For one thing, it’s likely that in a struggling economy, your customers are leaning on you to finance their own working capital needs. You’ve also had a few recent promotional programs, haven’t you, where you were offering extended terms to your customers? Because that may help improve the situation.” I finished taking John through the similar calculations for DIO and DPO and began to explain the implications.

“So, John, if you put that all together, you can see in the ‘Now’ column that you have 96 days in your sales cycle. That means it takes 96 days from the date inventory is owned by you until you sell it and collect the AR. Thirty-six (36) days of this cycle (DIO of 107 less DPO of 72) is how long, on average, you’ve invested in inventory after you’ve paid the vendor. Add 60 days to get paid and you can understand the 96-day period.

“Said another way, John, you have $20.5K/day of your own money – not the vendor’s – invested for those 36 days, which equals about $738K. Further, you’ve got $27.4K/day invested for 60 days in AR, which equals about $1.664 million. So, your total working capital investment is approximately $2.4 million.

“Now, look at the ‘Revised’ column. By paying close attention to working capital management, let’s assume you can reduce the sales cycle by just 12 days. You should note that improving your gross margin, which I’ve bumped up in this example from 25 percent to 30 percent, can also favorably impact this change. As a result, you can see that those 12 days are worth $300K, which is that much less cash that you need to borrow to support your working capital needs.”

Sound cash and working capital management is the cheapest investor you’ll ever find.

•••

Lary Kirchenbauer is the president of Exkalibur Advisors Inc. Please visit his Web site at www.exkalibur.com for supplemental materials related to this column and to learn about the CEO Round Table.

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