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In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give a basic understanding or refresher of a term and some useful tips from our consultancy practice.
Working Capital is one of the most undermanaged aspects of companies financials. Often it is simply not optimized due to a lack of awareness or attention. Many companies don’t systematically track or report granular data. They miss out on significant cash optimizing potential.
The cash conversion cycle (CCC) is a metric companies use to assess effective cash flow management and optimize their cash flow. The ratio provides an indication of how long it takes in days to convert a company’s investments in inventory into cash. The process covers the time it takes to sell off inventory (Days of Inventory Outstanding, DIO), collect payments from customers (Days sales outstanding, DSO) and pay suppliers (Days payables outstanding, DPO). Whereas DIO and DSO are correlated with the company’s cash inflow, DPO resembles cash outflows. This can be summarized in the following formula:
Cash Conversion Cycle = DIO + DSO – DPO
The first part, DIO simply measures how long it will take the company to sell its inventory. The formula for DIO is as follows:
DIO = Average Inventory/Cost of Goods Sold x 365
An increase in DIO means it is taking longer for the company to sell its inventory. The smaller the number, the quicker it is selling inventory. This can be positive as demand for the company’s products might be high. However, further analysis might be worthwhile if limited inventory levels hinder the company’s ability to satisfy customer demands. The second part, DSO measures the amount of time that it takes customers to pay the company for the purchased goods and services. The formula for DSO is:
DSO = Average Accounts Receivable/Total Credit Sales x 365
Obviously, if “cash-only” sales are the dominant payment method in a business, this ratio is zero. However, common payment terms in B2B are approx. 30 days as people use credit to finance their purchases. In order to manage the company’s cash flow a quick payment by customer’s, hence low DSO is favored in order to pay off suppliers without using external financing sources. An increase in DSO represents that the cash collections are not properly carried out. Customers are not paying on due time or the company is extending the payment date in order to ensure a deal. If this is the case, a thorough analysis of the company’s debtors should be undertaken.
The last part, DPO is the ratio related to the average number of days it takes a company to pay its suppliers. The formula is as follows:
DPO = Average Accounts Payable/Cost of Goods Sold x 365
An increase in DPO is actually better, as it means the company has more time to collect payments from its customers to pay off its suppliers.
Overall, the shorter the cash conversion cycle is, the better the company is performing at processing intermediate products, selling inventories and recovering cash from these sales while paying its suppliers. Contrary, a rising CCC can indicate several operating challenges that need to be monitored (e.g. slow moving stock, key customers in financial distress or payment conditions by suppliers that are unfavorable).
Besides management, the ratio is also critical for other stakeholders (e.g. investors, credit analysts, banks, etc.) Tracking the CCC over multiple quarters can provide a view into the management attention working capital management receives, the optimization potential in this area or potential cash levels that need to be sustained.
How well working capital is managed can be monitored through various ways. Starting with a multiple period analysis of the CCC, the ratio can be benchmarked with industry best practices or its competitors.
Optimization potential can be realized in different ways affecting e.g. DSO and DPO.
Possible opportunities to shorten DSO include, but are not limited to:
Besides these examples, one commonly used tool to reduce DSO is factoring. Factoring means that a business sells its accounts receivables at a discount to a third party which then collects the payments from a business customers. Depending on the discount this might be a possibility to optimize working capital.
Possible opportunities to increase DPO include, but are not limited to:
Based on these suggestions, the question comes to mind, whether it is possible to generate a negative CCC. The answer is yes. It means that that specific business model receives money up front or much quicker compared to the time it takes to make payments to its suppliers.
So what role does the CCC play in a post-COVID-19 economic framework?
Many companies will see the CCC increase, as the DIO will increase due to the downward trend of the operations and hence higher stock levels (e.g. clothing that cannot be sold due to store closures). Customers might not be able to pay on time, which will have an impact on the DSO. Suppliers might want to receive payments up-front due to high economic uncertainty. Overall, the CCC will increase, making it even more important for companies to optimize its working capital management in times of crisis.
A diligent use of the CCC might shift the loyalty with customers while also increasing the market share in a volatile economic landscape. Increasing the level of inventory in times of low demand might equip a business to gain market shares during the recovery period as it might be one of the few business able to satisfy suddenly increasing demand. Analyze your debtors / customers thoroughly. Some might be in economic distress and hence thankful for loyalty and support during a crisis. Increasing payment terms with these customers might initially increase DSO and hence the CCC, but in the long term this approach might secure a long-standing customer relationship. Developing trust with suppliers during a crisis is also important. Being transparent with the current business information and communicating financial figures despite uncertainties are key to establishing trust.
To sum it up, an active approach to manage the CCC – analyzing inventory levels, developing and nurturing long-standing customer relationships and further establishing trust with business partners – can prepare companies to quickly bounce back once a recovery sets in.
Juan Herrero
Partner
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Tobias Neukirchner
Transaction advisory | Mergers & Acquisitions
