Cash cycle: turning inventory into cash
The cash cycle — also known as the cash conversion cycle — is a key performance indicator (KPI) aimed at knowing the efficiency of a company’s business cycle. Specifically, it measures the time it takes from the point a good or raw material is purchased until the company receives the money associated with the sale of that item or the product into which it has been transformed. Closely following this logistics KPI facilitates the organization’s strategic planning and ensures greater stock control.
In this post, we explain the ins and outs of the cash cycle, the formula used to calculate it, and the logistics benefits it can bring.
What’s the cash cycle?
The cash cycle is a logistics and economic metric that measures the period between the acquisition of raw material for production and the collection of payment for the sale of the final product. In other words, it’s the time it takes a company to turn its stock into cash.
This parameter, thus, shows how efficient an organization’s business cycle is (from the procurement of goods to the sale of stock), by indicating how many days it takes the firm to recover its initial goods investment. The cash cycle lets you know the effectiveness of your company’s strategic planning and warehouse management. In this sense, the lower the cash cycle, the more efficient it is. A high result, on the other hand, could mean that the organization’s stock management policy is flawed.
To analyze this KPI correctly, it’s necessary to contextualize it with the company’s history and with the sector averages. If an organization’s cash cycle is very high above what’s expected for the sector, in the long term, it could have liquidity issues and lose competitiveness.
Cash cycle formula: how to calculate it in 4 steps
The formula for calculating the cash conversion cycle is based on these variables: how long the company takes to sell its stock, how long it takes to receive the proceeds from its sales, and, finally, how long it takes the firm to pay off its debts.
Cash cycle = days sales of inventory + collection period - average payment period
These are the steps used to perform the calculation:
- Step 1: Determine the days sales of inventory (also known as days inventory outstanding – DIO)
Days sales of inventory reflects the time the stock remains stored before being dispatched. That is, it illustrates the quantity of days that go by from the time the good is received (or the final product is manufactured) to its subsequent sale and shipment.
- Step 2: Determine the collection period (also known as days sales outstanding – DSO)
This KPI expresses the number of days that elapse between the sale of merchandise and the receipt of the money generated by the transaction. So, it’s essential for finding out how quickly a business collects money from its customers.
- Step 3. Determine the average payment period (days payable outstanding – DPO)
This variable shows the number of days between the acquisition of raw material or the contracting of a service and the date the corresponding payment is made. Therefore, it reflects how quickly a business pays its suppliers.
- Step 4: Apply the cash cycle formula using the values above.
Example of how to calculate cash cycle
Let’s take as an example a company with a days sales of inventory ratio of 50 days, a collection period of 30 days, and a payment period of 35 days. To calculate the cash conversion cycle, we have to add the first two variables (50 days + 30 days) and subtract the days payable outstanding (35) from the result obtained.
Cash cycle = 50 days + 30 days − 35 days = 45 days
So, the cash cycle of this hypothetical company is 45 days, meaning that this is the period elapsed between the time the initial investment in the goods is made until the cash generated by the sale of the product is received. As mentioned above, companies often look to operate on a tight cash cycle; this way, they can be sure they have the liquidity they need to guarantee the viability of their operations.
How does the cash cycle affect warehousing logistics?
The cash cycle equips the logistics manager with accurate information on the viability of the business cycle, which makes it easier to identify logistics planning issues.
The longer it takes to turn stock into money, the higher the stock management and logistics storage costs are likely to be. That’s why this KPI is extremely useful for, among other types of companies, large consumer goods firms, with extensive product catalogs and complex payment flows. Since they deal with a wide variety of SKUs and a high turnover, it’s crucial to manage the stock properly and to maintain effective control over the times between payments and collections.
From a logistics point of view, one way to improve the cash cycle is by keeping the time a good stays in the warehouse down to a minimum. The extreme version of this is cross-docking, an order preparation method whereby the products are dispatched directly upon receipt, with no interim storage period. Another possibility, particularly common among e-commerce companies, is drop shipping. With this method, the supplier sends the order directly to the customer, so the seller doesn’t even manage the product in its facilities.
In any event, the goods normally spend a certain time in the facility. In these cases, the way to reduce the cash cycle is through the days sales of inventory variable. And to do this, it’s vital to be armed with a warehouse management system (WMS), such as Easy WMS from Interlake Mecalux, which will enable you to measure and monitor that metric. Plus, since it directly oversees operator tasks, it cuts times and optimizes all operations (goods receipts, picking, dispatches, etc.), consequently improving this KPI. Likewise, in turn, shipping errors go down, doing away with returns and refunds that are detrimental to the collection period and the cash cycle.
Efficient warehouse for a healthy cash cycle
The cash cycle is an effective tool for detecting inefficiencies in stock management. An elevated cash conversion cycle could be related to poor warehouse management, leading to the loss of perishable goods or to customer complaints due to wrong orders. On the other hand, if the facility is efficient, the days sales of inventory will be low, and it will be easier to adjust collection periods (by minimizing reverse logistics, for example). And this is made possible through good warehouse organization and data analysis, which is why installing robust logistics software is an absolute must.
Looking to equip your logistics operations with efficient tools that will make the most of your warehouse throughput? Don’t hesitate to contact us. Interlake Mecalux has a wide array of solutions to ensure maximum effectiveness and productivity for all types of companies.