In this series, we’ve examined the severe storm that today’s wholesalers and retailers must weather in terms of cashflow issues, as well as some of the way responsible inventory management can help to minimise these problems. Today, we are going to be focusing on measurement, and introduce some of the key metrics retailers and wholesalers can use to keep on top of their cash flow.
In simple terms, the cash conversion cycle – or CCC – is the length of time, measured in days, taken for a company to convert the investments and assets in its inventory into cash generated from sales. There may be other resources which are also factored into these calculations, but, for most businesses, the bulk of this cashflow will be coming from stocked products in inventory. And this is important – as a business owner, you invest in products because you want them to sell and generate profit for your organisation; understanding how quickly this is achieved is vital.
So, the quicker you can convert invested cash into end returns and profits – i.e. the lower the ratio of the CCC – the better.
Calculating the CCC means considering three distinct stages of the cashflow conversion process.
Firstly, the existing inventory level is taken into account, and we consider how long it will take for a business to sell off its inventory. This is represented in the calculation as Days Inventory Outstanding – or DIO.
DIO = (Average inventory / COGS)*365 days
Secondly, the calculation examines the current sales and the time taken to collect cash generated from these sales. This is the Days Sales Outstanding figure – or DSO.
DSO = (Average Accounts Receivables / Revenue)*365days Thirdly, the calculation focuses on the current outstanding payables relating to the business. This usually relates to money owed from the company to its suppliers for the current inventory. In terms of the calculation, the figure is the time period, in days, for the company to pay off this debt, and is represented as Days Payable Outstanding.
DPO = (Average Accounts Payable / COGS)*365 days To complete the calculation, we use the following formula;
Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO)
or;
CCC = DIO + DSO – DPO
Getting these three smaller calculations right is vital, however, and these must be completed before the cash conversion cycle can be gauged.
What is it that makes the cash conversion cycle such an important metric for your business? There are actually two key factors here. The first is that CCC is a clear indicator of efficiency in handling and managing working capital assets, particularly critical assets such as inventory. The second is that CCC offers a viewpoint from which to gauge liability management; i.e., how effectively is a company able to pay off its current liabilities.
Most contemporary financial reporting focuses on quick and current ratios, designed to measure how quickly an organisation can sell its inventory to make way for more stock. However, the CCC takes things a step further, measuring how quickly the company can turn this inventory into sales and then turn these sales into receivable cash, making this ratio a far better demonstration of company liquidity.
The CCC also helps us to identify where cashflow issues are coming from. The longer the inventory remains unsold, the longer it takes to collect the accounts receivables. When we factor in a shorter payment window for debts to company suppliers, we can deduce that cash is being tied up in inventory, and available cash is being quickly depleted as trade payables are managed. Over time, this trend will squeeze the available cash a company can draw upon, greatly reducing liquidity.
This is why the CCC’s individual components are so critical to business. Business owners can use these smaller calculations to spot positive and negative trends in the way in which their company manages its working capital. When the CCC ratio is lower, there is less need to borrow additional capital, and more opportunity to achieve pricing discounts through direct cash purchases on materials. There is also an increased capacity for growth and expansion. This is what we should be working towards.
Let’s look at how CCC works. As an example, John is a wholesaler selling bathroom accessories to large residential developments. John purchases his inventory from one main vendor and pays off the outstanding balance on accounts within 30 days to achieve a discount. The inventory turnover rate of John is 4 times a year, and he collects accounts receivable from large property developers generally within 45 days on average.
This translates to;
Days Inventory Outstanding (DIO) – 90 days
Days Sales Outstanding (DSO) – 45 days
Days Payables Outstanding (DPO) – 30 days
DIO + DSO – DPO = 105 {compare to average SME at 84 days} So, John’s cash conversion cycle is 105days. In other words, it takes one hundred and five days to get from paying for inventory to receiving the cash from the sale.
PWC’s working capital study highlights how the CCC is strongly favorable for large organisations compared to smaller businesses. This is driven by things such as better processes, superior systems and most importantly positive payment terms leveraged by simply being large. According to the PWC report the average CCC for large enterprises is 37 days (just over a month) compared to 64 days for a mid-tier enterprise and a staggering 84 days (nearly a quarter of a year) for small business. A significant difference.
Based on the above, at a minimum, John can look to improve his current CCC from 105 days to a minimum of 84 days (as suggested by PWC). This can be achieved by focusing on supply chain management to reduce inventory levels, debtor collection (offer discounts for 7-day payment or offer online settlements) and negotiating better payment terms.
Over the course of this series, we’ve really got to grips with some of the cashflow issues affecting Australian retailers and wholesalers. We’ve analysed some of the factors which are harming cashflow, and how alternative finance can provide a solution. We’ve also looked at how better inventory management can reduce the strain caused by cashflow, and outlined some of the calculations and metrics you can use to monitor cashflow in your business.
Together, these elements help you to create a robust defence against what is potentially a catastrophic issue. Measure your cashflow, manage and mitigate the factors which impede it, and secure high levels of efficiency and efficacy for your organisation.
The previous article in this series, The Cashflow Gap (Part 1): What’s Causing the Gap, and How Can Retailers and Wholesalers Close It, outlined the problems facing today’s businesses in this sector. In today’s piece, we’re going to take a more positive view, and examine how retailers and wholesalers can manage this widening gap through inventory management.
Recognising the signs of a poor Cashflow
Before we can act on cash flow problems, we first need to recognise them. By applying certain calculations to our inventory, we can keep a watchful eye on the early signs of cash flow issues. Once we identify them, we can stop them in the act.
Calculate your inventory cashflow
Something you need to know is if your inventory will be able to meet the demands placed by your client. The calculation here is simple –just examine this year’s inventory balance alongside last year’s inventory balance. If the balance has decreased, year on year, this represents cash inflow – i.e. you have exchanged inventory items for cash. If there is an increase, this indicates unsold items, and a cash outflow, both of which can lead to problems.
Understand your stock turns and calculate inventory turnover
It is important to understand the number of stock turns you are seeking to achieve as a business. For instance, some retailers focus on 4 turns a year whilst a wholesale distributor may focus on only 2 turns a year.
Inventory turnover is basically the time it takes for you to sell your entire inventory. Use the following calculation.
Inventory turnover = Cost of goods sold / (0.5 x Opening inventory + 0.5 x Closing inventory)
If the result is 4, for example, this means you completely sell out and replenish your inventory four times a year. This number will help you to recognise whether your stock levels are too high or too low so you can adjust accordingly.
Understand inventory in real-time
Insight and understanding are key elements of modern business, particularly as the business landscape becomes increasingly data-driven and data-oriented. However, it is not enough just to know your inventory and your stock levels. You need to know this information in real-time.
This means deploying a solution that gives you up-to-the-second updates on stock levels. This gives you the power to enhance your customer experience and boost the efficiency of your replenishment procedures, while also giving you direct insight into how cash flow is manifesting itself on the warehouse floor.
Emma & Tom’s is a proudly Australian-owned business offering healthy minimally processed fruit products. They were experiencing a rapid growth and were required to manage multiple inventory locations. Dealing with fresh foods required zero lag in operations and inventory. They made a decision to implement an ERP system that enabled them to effectively manage their inventory. This resulted in a 30% growth year on year growth.
Implement ‘Just In Time’ model to streamline your supply chain
Wastage and shrinkage have an enormous effect on cashflow. If your stock is lying around for weeks or months in a warehouse or on a shop floor, this is just increasing the likelihood of shrinkage and reduced profits.
A Just in Time (JIT) supply chain model can help in this regard. Ordering in products or materials at each stage in the process, so they arrive ‘just in time’ to be used and then sold to customers, means that this latency period is eliminated and wastage is greatly reduced. The knock-on effect is improved cashflow at your end.
Pioneered originally by Toyota in the 1960’s, JIT inventory control is used for ordering parts when they receive new orders from customers. While JIT supply chain model works well for mid to large enterprise businesses, it may not work for small businesses. Supply-management consultant Johnson argues that small businesses don’t have the purchasing power or the linear demand frequency that is required for adopting JIT model. However, enterprise resource planning software solutions such as SAP Businessone are now becoming popular among small and mid-size businesses. SAP Businessone’s real time data analytics tools helps business owners get a clear picture of their supply chain at every level. Therefore, simplifying the entire supply chain process and helping businesses adopt a JIT methodology.
Better flexibility with supplier
Your suppliers are business people just like you and so they too understand the difficulties businesses can encounter when it comes to cash flow and inventory management. Aim to develop good relationships with your suppliers and to bring about a situation in which they are happy to work with you to provide the terms you need to get cash flow problems under control.
It may be necessary to renegotiate credit terms with your supplier, giving you more time to pay for any outstanding inventory bills you may have. This, in turn, provides you with additional breathing space when it comes to managing inventory cash flow. However, as mentioned, suppliers are business people too, with their own issues and their own bills to pay. As such, all negotiated terms must be mutually beneficial.
Work with suppliers who deliver on time
Which products are your best sellers? Which products are flying off the shelves and into the hands of customers? Which products are taking longer to shift? Knowing this is key to gaining a firm grasp on the management of your inventory.
From here, you can turn your attention toward your suppliers. For example, if a supplier is delaying sending out stock that flies off the shelves and needs to be instantly replenished, this is going to lead to delays, which will in turn harm cash flow. In this case, you should consider working with someone else. On the other hand, if the stock is a slow-burning seller and is difficult to find elsewhere, it may be worth continuing to work with the seller. It all comes down to understanding product demand and your inventory needs.
Facilitate and incentivise instant payments
We may consider invoice lag to simply be a fact of life. We deliver the goods our clients need, we provide the invoice, and we wait. However, this is not always the case – it may be simply that the facility for instant payment is not readily available. No one likes unpaid bills hanging over them. You may find that making it easy for your customers to pay instantly via credit or debit card significantly reduces your cash flow issues.
You may also decide to offer discount programs and other incentives to encourage this kind of instant payment, although you must make certain that these schemes do not erode your profit margins too greatly.
Manage your cashflow
Some suppliers require a 30-50% upfront payment on ordering. A combination of debt facilities and trade refinance facilities can help small businesses to manage the inventory sales conversion pipeline.
Cash flow is exactly what it sounds like – a flow of cash. It is not always necessary to receive a full payment upfront but you do need to ensure that the cash is flowing towards you at a predictable and manageable rate. This can be achieved through factoring.
For example – X Company receives an order for $1,000 of deliverables, which are sold with a 20% discount. They receive $800 up front, and the further $200 is delivered on a payment plan which is carefully managed and monitored. Adherence to the payment plan may result in X company offering a further discount once all cash is recovered if incentivisation becomes necessary.
Any wholesaler or retailers understands how difficult cashflow can be to manage. However, in today’s market, the shortfall between paying for inventory items and recouping this capital through sales is growing. So what does this mean for Australia’s businesses, and what are their options?
A recent report published by Xero exposed a staggering 62% of small businesses faced a late or unpaid invoice. However, today’s cashflow problems go beyond this. In the current economic climate, wholesalers and retailers are being hit by a decline in the Aussie dollar and a recent trade war between China and the US.
In July 2018 Western Union currency strategist Steven Dooley and corporate hedging manager David Evans-Marcius discussed some of the challenges facing Australia’s retail and wholesale sector. They expressed their concerns with particular regard to the Australian dollar, which slumped by 5% on FX rates in June alone, placing immense pressure on small businesses.
So what is causing this sorry state of affairs? You may already be aware of some of the age-old causes of a cashflow gap. You may have experienced the challenges they pose yourself.
These include:
Many businesses are happy to let some of their profits slide rather than methodically collecting all receivables due. Many consider this simply to be an unavoidable cost of doing business. Don’t fall into this trap. Instead, make it your priority to receive the money you are due on every transaction.
For many retailers, the simple fact is, their outgoings especially property rent are too high while their volume is too low. Redressing this balance is a major step towards securing a healthier cashflow rate for your business.
David Finkel, writing for Inc.com in 2014, highlighted how many retailers are way off in their pricing. Finkel explained that the common reaction to a cashflow issue is to drive sales by dropping prices. However, if prices are too low, even an increase in sales is going to harm your returns as every item sold represents missed potential.
Businesses need funding in order to grow and to thrive in the market. Often, this funding and financing can be difficult to secure.
With Australia highly exposed to global trade and global trade expectations, growing tensions between the US and China have seen the AUD/USD lower. This has caused costs to rise for both retail and wholesale businesses.
As Evans-Marcius and Dooley explained, the international trade war is just one-factor causing problems for the AUD market here in Australia. Other factors weighing in the AUD include:
Unfortunately, none of these currency related factors look likely to change in the near future.
The above international trade factors have resulted in an FX spot rate at well below most businesses budgeted forecast. Budgeted rates need to be competitive and achievable in order to maintain a strong position in the market. As most SME wholesalers and retailers do not have the luxury of adjusting their budget rate, they may need to rely on “defensive hedging” to cut any losses and to afford protection for their business.
Defensive hedging – i.e. taking a hedge from a position of weakness – is not healthy for the sector, and is likely to prove to be a stop-gap move rather than a viable long-term solution.
In such turbulent times, finding an effective solution is vital. In this section, we will examine the effective methods for navigating this new retail landscape and for closing the yawning cashflow gap.
Never undersell your products. It is better to sell a reduced volume of products at close to their market value rather than desperately offload your inventory at a discounted rate.
Put a plan in place for maximising collections on all your receivables and for accelerating the process. Make sure invoices do not fall through the net.
This kind of streamlining may not always be possible, especially with very large retailers. However, trying to negotiate a reduction in your payment terms from 120 days to 90 days can hugely benefit your cashflow cycle.
Alternative lenders such as Banjo Loans can provide effective short-term funding to help you close the cashflow gap.
Rather than letting things turn sour with a supplier, consider negotiating extended terms while cashflow problems persist.
Businesses can reduce the risk posed by the dollar’s FX rate by;
By stepping up to the cashflow gap now, retailers can turn things around and thrive, even in today’s more challenging business climate. Next up in this series: The Cashflow Gap (Part 2): How retailers and wholesalers can reduce the gap by managing inventory.
Starved of credit?
At Banjo, we share in the vision of small businesses, we love hearing exciting business ideas and inspirational stories of business success. Most of all, we like to see people out there pursuing their passion. There are 2 million small businesses in Australia employing around 49% of workers and representing some 97% of all businesses in Australia. These stats make it clear that we all benefit if small business, the backbone of our economy, has the support and environment to develop and grow their businesses.
So we were perplexed that now, 7 years after the GFC, small businesses globally remain starved of credit and Australia is no different. One issue raised frequently in the small business sector is; ‘why is it so hard to get the funds we need to grow our business?’
Of 2 million SME’s (Small to Medium Enterprises) in Australia, 51% have no lending product at all and they are typically funded with family loans or credit cards at rates closer to 25% without generally adjusting pricing to reward lower risk borrowers.
Funding for SMEs globally has become constrained during the recession and stayed at these low levels since: it is generally more profitable for traditional lenders to make a $2m loan than a $50,000 one.
Post GFC traditional lenders have grown their personal and home loan credit books at much faster rates than their small business books. This has been attributed to a number of factors such as the relative riskiness of SME loans to housing loans, greater capital requirements for SME compared to other forms of lending and finally reduced competition amongst business loan providers post GFC.
Submissions to the recent Financial System Inquiry[i] stated structural issues such as information asymmetry, regulation burden and the taxation system also as possible contributing factors to the lack of business finance provision to SME’s.
There are a number of initiatives being implemented internationally aimed at addressing the same issues Australian SME’s face accessing finance, and we could consider some of these as roadmaps for our creation of a better SME world.
In the UK, high-growth businesses with low levels of fixed assets also have difficulty accessing credit. The UK Government launched a number of initiatives to support small businesses following a 2012 Parliamentary Review[ii] such as:
In the US, two initiatives in addition to those above caught our eye:
At Banjo, we take an active role in advocating for small businesses in Australia. SMEs are the job creators and innovators we need to keep the Australian economy growing.
Banjo introduces a new online marketplace lending platform built by Australian banking experts who simply thought there must be a better way to provide unsecured loans to SMEs. We want to make it easy so business owners can get on with what they do best!
Increased competition in Australia will be good for business.
Recent calls by the industry to reduce the red tape burden on SME’s by automating BAS and income tax returns are positive initiatives. We support the government task force working to explore the potential of technology and digital platforms joining with the Government to make it easier and more streamlined for businesses to interact.
Over the coming 12 months, the team at Banjo will place their shoulders on the wheel to work with Government, Industry Bodies and the Banking industry to explore ways in which we can all work together to create the right environment for small businesses to flourish in Australia.
Imagine being able to just get on with the business of running your business!
Sounds just brilliant to me.
[i] www.australiancentre.com.au
[ii] www.gov.uk/government/consultations/sme-finance-help-to-match-smes-rejected-for-finance-with-alternative-lenders/sme-f
