Everything you need to know to keep your cash flow positive, use your creditors to fund your business, and make your numbers work for you.
The success of a business is often judged by its rate of growth and its number of employees. The problem is that both a business’s rate of growth and its size come with their own demands and consequences, which are often ignored in the pursuit of more and more growth.
The reality is that not all growth is created equal. If your business doesn’t have scale, you can end up growing yourself into trouble — or even out of business.
Even more important is positive cash flow. Is that great new contract bringing in money, or costing you money? Shouldering an upfront cost for growth down the line is all part of the growth journey, but only if the numbers make sense and you know when your investment will turn to profit.
Here’s the secret to growth: It can be self-funded. Yes, there are venture capitalists, private equity firms, angel investors, bank funding and a host of other ways to access finance — but you can grow a large, successful organisation without any of these.
The trick is to know your numbers. Here’s how you can practically apply the rules of positive cash flow to your business.
Related: Gain a competitive edge - have more (effective) conversations
The Power of Cash
In 2012, Amazon’s share price was $173. By 2016 this had grown to $725. Walmart, arguably the biggest retailer in the world, went from $59 to $70 in the same period.
But take a look at Table 1 for the revenue growth of both companies between 2003 and 2012 (a trend that has continued).
How can Walmart’s stock price have hardly increased, while Amazon experienced impressive growth over the same period, despite the fact that Walmart’s revenue growth far outstrips Amazon’s (in absolute, not percentage terms)? Is Walmart’s stock undervalued, and Amazon’s overvalued? Even accounting for growth off a low base, how can we explain this?
The share price is simply the net present value of future free cash flows generated from the efficiency of an organisation in managing cash to generate more sales.
In other words, Jeff Bezos’ focus on his cash conversion cycle has meant his business is incredibly cash-positive, which has in turn positively impacted Amazon’s stock price. Although Amazon is a highly unusual business with its negative cash conversion cycle, and its actual liquidity is somewhat contested by the investment community, it’s a great example of getting customers to fund growth.
The Cash Conversion Cycle
We agree that it takes money to make money. A business, even one with a tight, scalable business model, will consume more cash in its growth phase than in its steady state, or execution phase.
But, you don’t want to ever spend more money than you need to — or can reasonably afford to. This is true whether you’re self-funded or spending someone else’s cash, but particularly if you’re funding your own growth. Dealing with unplanned funding can be costly, time-consuming and it hampers growth. It also bogs you down in stressful admin when you could be focused on the elements you love and that excite you.
There are two questions that you should have asked yourself as you embarked on your growth journey (note: if you’ve never asked these questions, you need to surround yourself with like-minded business people who can help you find and ask them):
- For what period of time is my money tied up in inventory and other current assets before customers pay for the end product or services?
- How much cash do I need to finance each unit of sale and what is the amount of cash generated by each unit of sale?
I guarantee you that Jeff Bezos knows the answers to these two questions. Not his accountant or financial director — Jeff himself. You can’t abdicate the numbers of your business to someone else. Understand the difference between delegation and abdication. You don’t need to be doing your business numbers but you absolutely need to know what they are. This is one of the most important metrics of your business.
Let’s go back to our example of Amazon (see Table 2): Bezos’ cash conversion cycle (measured in days), oscillates between -40 and -8 days. That’s the secret.
In other words, Amazon uses other people’s money to fund its operations. That’s an extremely valuable business model, as its share price demonstrates.
Walmart’s cash conversion cycle is also a very respectable 11 days. As a business model it’s not quite as valuable as Amazon’s, but there’s a reason why Walmart is an international leader in its industry. It takes this behemoth organisation just 11 days to convert $1 into something worth more than $1. It then recycles that original $1 a further 35 times per year. Walmart’s margins are not high, but the compound growth is very powerful, as we’ll see later.
Related: When is it time to cut the ties to your business?
Let’s Get Started
Step 1: Understand your business
To better understand the components of your operating cash cycle and your cash conversion cycle, take a look at Diagram 1.
Operating cash cycle (OCC) is the period of time between when you start the assembly of all the required inputs into your production line, and cash comes back into the business as payment for the sale. Remember, if you’re a B2B business, there’ll be a delay between when the customer starts using your product and service, and when payment is made as well. This difference is referred to as accounts receivable days. Likewise the time between when your production starts (having received inventory) and the moment your business pays for this inventory, is the accounts payable days.
Cash conversion cycle (CCC) This is the period of time that working capital is tied up. It’s the time between when cash was converted into one of the inputs for your production line, and when the product is converted back into tangible cash, handed to you when customers pay you in real money. It’s the difference in time between your operating cash cycle and account payable days.
Self-financing growth rate (SFG)
This is the crux of this article. Your SFG rate is the rate at which growth can be sustained by cash generated by your business without any external funding.
Step 2: Working out your cash conversion cycle
Where can you access the figures you need to determine your own OCC, CCC and SFG? First, use data spanning a 12-month time period. This has two advantages: You have a better chance of sourcing accurate data if it comes from a signed off financial statement, and you can dampen the noise caused by seasonality.
Work with your balance sheet and income statement.
Working out conversion days from balance sheet
||ZAR amount on (000)
||ZAR amount on (000)
|Plant & equipment
Working out conversion days from income statement
||ZAR amount on (000)
||ZAR amount on (000)
||Day equivalent in (000)
||Ratios in %
|Revenue / Income
||= 2 000/365 = 5 479
|Cost of sales
||= 1 200/365 = 3 288
||= 700/365 = 1 918
|NPBT – net profit before tax
Based on the above example and figures, we have determined the following information:
- This business generates R5 479 of income per day at a cost of R3 288 per day.
- Calculation A: We owe a total of R99 000 to our suppliers, which at
R3 288 per day is ~ 30 days from
99 000 / 3 288
- Calculation B: We are owed R384 000 from our customers, which at
R5 479 per day is ~70 days from 384 000 / 5 479
- Calculation C: The amount of inventory we have paid for and need to turn into a sold product in equivalent days is ~ 80 days from 263 000 / 3 288.
Our original ‘as-is’ timing diagram now looks like this:
We still need to account for operating expenses, including salaries, utilities, rent, marketing costs and so on, and we can safely assume (but check this for your business) that bills arrive uniformly over the 150 day OCC period, meaning some will be paid immediately (day 1) or have to wait (day 150). On average this is 75 days.
You should now interpret the information as follows;
- The OCC is 150 days, but because the business has 30 days to pay its suppliers, the CCC is 120 days. In other words, cash is tied up for 120 out of 150 days (80% of the time).
- In terms of operating expenses, we assumed a uniform distribution over the period whereby some creditors would be paid immediately and some would have to wait for the 150-day cycle to finish. On average, this leaves us with 75 days or 50% of the OCC.
Related: Adapt your approach, or face the prospect of failing
Step 3: Unlock capital in your business
We now know for how long our cash is tied up, but we still need to determine how much is tied up. Using the ratios in the original income statement, we can now answer the following: What amount of cash is needed to finance each unit of sale, and what is the amount of cash generated by each unit of sale?
Cash conversion at work on your Is
|Income statement line
||with CCC factoring
||effective per ZAR
|Cost of sales
||Cash tied up per 1 ZAR of Sales Revenue
|Profit before tax
|Free cash generated per ZAR of Sales
||Cash needed for each OCC
Putting it all together
Let’s look at what you now know about your business:
Self-funded growth rate
|The cash generated from 1 ZAR of sales
||By looking at the income statement ratio
|The time in days of your OCC
||Calculated from holdings inventory days + accounts rec days
||80 + 70 w= 150
|The CCC time to cycle cash used in the OCC
||Calculated from OCC - accounts payable days
||150 — 30 = 120
|The cash tied up in each OCC for a 1 ZAR sales income
||Restated IS with CCC factored in for OpEx and inventory
||0,18 + 0,48 = 0,66
|Your per cycle growth rate
||Free cash that can be added to the OCC cash requirement
||0,05 of 0,66 -7,57%
|How many cycles can be completed in a year?
||Days in year available divided by OCC
||365/150 = 2,43
|Assume a productivity factor for safety
||90% as a reasonable contingency for strikes etc
||2,43 x 0.9 = 2,19
|Compounded annual self-funded growth rate
||(1 + SFG) OCC cycles - 1) = (1 + 0,0757) 2.19 - 1 =
Driving growth in your business
So, how can you use this information to drive growth in your business?
First, your debtors book must exceed your creditors book. Then, if we just shorten our accounts receivable days from 70 to 30 days, the following would happen:
- The OCC is now 150 — 40 = 110 days
- CCC is 110 — 30 = 80 days
- Cash needed for cost of sales is 0,60 X 80/110 = 43 cents
- We have not targeted operating costs yet, which remain at 18 cents
- Round everything up and we now need 62 cents instead of 66 cents (6% improvement)
- Your per cycle growth rate is 5 cents/62 cents = 8% growth rate
- How many cycles can you do in a year now? 365/110 = 3,3 cycles; up from 2,43!
- This is a 36% improvement
- Add a contingency of 95%, which gives us 3,13 cycles
- Compound this over a year: (1+ SFG) nbr of cycles — 1) = (1 +0,08) 3,1 -1) = 26% from 17% originally.
That’s 9% growth and nobody noticed a thing!
- That large corporate account that you cherish and that one of your sales executives is overly proud of landing may well be destroying value in your business. Why? Because large corporate accounts tend to get over-serviced (and I doubt you allocate those costs properly) and tend to pay you late.
- Growing with a greater number of smaller customers, steadily over time, within your means and without being bullied delivers more value and less stress.
- There are easy and clever ways to add lots of value to your business, that cost very little to implement, but you do require an understanding of how cash gets tied up.
- Delegate, don’t abdicate. No entrepreneur is ever great at sales, production, operations and cash management, so get people who can complement your skill set, and allow you to do what you enjoy. That said, you can never hand the numbers over to someone else. Receive assistance if you need it, but know your numbers!
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