Optimizing the Cash to Cash Cycle

In the Supply Chain, we worry about service, inventory, and execution.  Do we have the right products, in the right place in the right quantities at the right time?  Are we doing it at the right cost?  Lastly, we are we relentlessly trying to lower costs, lead times, and inventories.

Our general management and finance colleagues have a slightly different view.  They are looking at revenues and profit primarily.  Probably a close second to this focus on the top and bottom line is cash management.  Cash is needed to both run and invest in the business.  To this end, Cash-to-Cash Cycle is a measure that general management and finance folks deem important and in which we, in the supply chain, need to pay attention to.  Let us consider the cash-to-cash cycle which is measured in days:

Average inventory days on hand
+
Average days to get paid by customers (AR Days)
–
Average days it takes to pay suppliers (AP Days)

The goal is to lower this measure.  It measures the gap between collecting from customers and paying suppliers.  If a company has 35 days of inventory on hand, collects from customers on the average of 30 days, and pays supplier in 60 days then their cash-to-cash cycle is 35+30-60 or 5 days.

Here are some examples from fiscal year 2009 of actual companies taken from the Cadent Resources Group database from which we provide benchmarks to our client.

A fast food giant	6.5 days
A major Auto OEM	121 days
A drug store chain	25 days
A pharmaceutical company	35 days
Your company	??
Your peers/competitors	??

The goal is to reduce this cycle by reducing inventory coverage and having customers pay us faster than we pay suppliers.  Finance and general management tend to drive this measure as much or more than other inventory and supply chain measures.

The supply chain will be tasked to reduce inventory.  We know the challenges we face in this area, it is a primary focus of this blog.  Sales will have objectives to get customers to pay faster.  General management might even pitch in on this one as they are often meeting with their customer counterparts.  Of course, customers, especially larger customers do not want to do this and if they do, they will want favorability in other terms like… pricing.

The easiest thing to do, by far, is to simply delay paying our suppliers.  Often, finance does this as a matter of policy change that may or may not be communicated to the supply chain and purchasing managers.  Suppliers will protest but the protests will fall on deaf ears except for the rare circumstance when the supplier has the upper hand.

As many things in business, this measure requires a balancing of the three components.  The easiest thing to do is to keep delaying the paying of suppliers but this risks their goodwill and loyalty at the minimum to perhaps putting suppliers in a precarious financial situation in the latter.   Bankrupting our suppliers is not a business practice we recommend.

It is better to work on all three.

1. Work to optimize inventory levels to have the right products in the right locations in the right quantities at the right time.


2. Work to gain fair terms with customers and measure their performance against it.  Use this information in negotiations with customers especially at the top-to-top meetings.  A tradeoff can always be made between pricing and payment terms.


3. Based on 1 and 2, set fair payment terms with your suppliers to get favorable pricing, delivery, or other benefits that can help reduce your working capital exposure.


4. What are competitors and near competitors doing in this regard?  If their Cash-to-Cycle is considerably different, we need to know why and evaluate if there is something to be learned.

The table below describes the impact of the trade offs as related to cash and working capital employed.

• Scenario A is the baseline.  Company has a 30% gross margin, 8 inventory turns, AR days of 45, and likes to pay its vendors in 52 days.  In turn, it has extended its cash out 123 days and has $1,900 in working capital employed.  This is a pretty typical scenario.


• Scenario 2 is a trade off of margin in favor for faster payment terms.  In the case below, the company has extended a savings of 3% to secure 35 day payment terms.  Though the gross margin has been cut, the benefit is an increase in cash of $290K that can be used to invest in growth or margin improvement activities.


• Scenario 3 builds on the AR improvements by addressing inventory.  In order to do so, the company decides that they will decrease their payable cycle to 33 days as incentive for their vendors to reduce delivery lead times which will help reduce inventory.  The improvement drops their inventory investment by $250K and reduces their working capital outlay by another $150K.

	A	B	C
Revenue	$10,000K	$10,000K	$10,000K
COGS	$7,000K	$7,300K	$7,300K
GROSS $'S	$3,000K	$2,700K	$2,700K
GROSS MARGIN %	30%	27%	27%
(+) INVENTORY	$1,000K	$1,000K	$750K
INVENTORY DAYS	120	133	100
INVENTORY TURNS	7	7	10
(+) AR	$1,250K	$960K	$960K
AR DAYS	45	35	35
(-) AP	$350K	$350K	$250K
AP DAYS	42	47	33
WORKING CAPITAL EMPLOYED	$1,900K	$1,610K	$1,460K
CASH CYCLE	123	121	101
ROCE	158%	168%	185%

Like any KPI, Cash-to-Cash Cycle needs to be measured, tracked, and compared to your competition.  You need to decide what your strategy and policy is in this area and then drive it.