The cash conversion cycle can send you broke.
How can a profitable business go broke?
The cash conversion cycle is a critical element of any business' cash flow requirements. If a good business is
starved of cash, it will go broke, no matter how profitable it might otherwise appear to be.
Businesses need to provide cash for inventory, overhead, debtors (offset by cash sales, and credit from
suppliers) in order to survive. This cash will be required regardless of whether the business is making a
profit.
The cash conversion cycle of a business (or an individual product, or asset) is the period of time between
paying for costs and receiving cash from sales. The cycle is usually measured in days, but could be weeks, or
even months.
Inadequate planning for the cash conversion cycle period is major reason for business failures. Booming sales in a business creates a booming demand for the resources it
consumes. Resources such as inventory, debtors, selling and distribution expenses, overhead and salaries must be
paid for.
If the payment for resources is required before the sales are banked, then cash must be put into the business
from borrowings or equity or asset sales. If not enough cash is available to fill the gap, the business is
bankrupt.
A good business plan importantly will disclose and explain the cash conversion time-period assumptions
which relate to the business operations. Assumptions will normally be expressed as a number of days for each
component of the cash flow, and need not be especially complicated, or difficult to calculate.
Relevant information will include:
- Available cash at the beginning of the forecast period
- Average number of days between invoicing and payment from customers
- Average number of days between invoicing and payment to suppliers
- Average number of days that inventory is held before making a sale.
Individual businesses will vary, and may well have time-lag factors which are peculiar to their industry or
business model.
The cash flow forecast will show the timing of cash flows in and out according to the number of days lag in each
cash cycle component, and by simple arithmetic show the net result (surplus or deficit) for each month and year of
the forecast period.
The cash conversion cycle is a crucial element of a business plan and should be very
carefully prepared, with good evidence supporting each assumption.
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