If you have taken any basic finance course through your undergraduate or masters work, you have heard the phrase “cash is king.” The point behind that statement is that cash flow is the lifeblood flowing through a business. Without cash, businesses cannot function. However, cash is often harder to track and figure out that bottom line net income. As a result, too many businesses do not pay enough attention to cash.
My favorite metric for tracking cash (and an organization’s management of it) is the Cash Conversion Cycle (CCC). The CCC tracks the “cycle time” of cash from when a dollar is spent on inventory to when a dollar is received as a payable. Typically, the smaller this number the better, and it can even go negative (see Dell below). The CC tracks this by following the cash as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash.
As you can see from the flow, once cash is used to purchase inventory, it is no longer available for any other investments or payables until it is received back in cash. Thus, you see why a lower number is typically better. Dell has made the CCC famous, and as of January 2011, they had a negative 28 days CCC, meaning they received cash 28 days prior to having to spend it on inventory (i.e. they “played” with others’ money).
How did Dell get a negative CCC? It is not complicated if you think about it:
1) Customer pre-pay for product. Dell is a build to order PC manufacturer (mostly), and customers pay for their PC prior to Dell pulling inventory and building the PC.
2) They hold inventory on consignment. Dell’s suppliers own the inventory of parts that is in Dell’s factories. Dell does not take ownership (or make payment) for the parts until they pull it from the bin to use it. Thus, they don’t buy inventory until after cash is received from the customer.
3) They have very short AR cycles (well under 30 days).
4) They pushed their payment terms (AP) out as far as they could. However, they are fair to their suppliers who have put inventory in on consignment, so they haven’t pushed out 60 days. They still stay around 30 days for payables.
That all adds up to a negative CCC, which means they can buy inventory with cash. That provides Dell a cheaper source of funds (versus a line of credit), and it keeps them from having to gamble on inventory buys.
What is your CCC? For 2012, I would encourage you to begin tracking your CCC, and working to lower it.