Cash is a critical resource for small businesses and their owners. An unprofitable company can quickly run out of cash and cease operations. Profitable companies can also run out of cash due to the levels of working capital and reinvestment required. One way to ensure that a company has sufficient cash on hand to pay its bills is to shorten its cash cycle.
Monitoring the timing and quantities of cash inflows and outflows is the crucial component of cash flow management. Cash inflows result from cash sales to customers, conversion of accounts receivable to cash, loans and borrowing, and asset sales. Cash outflows arise from cash payments for expenses, conversion of accounts payable to cash via bill payments, and principal and interest payments on debt. Companies that have strong cash flow management policies and procedures in place typically have shortened cash cycles.
A company's cash conversion cycle includes inventory purchases and conversion, accounts receivable conversion and accounts payable conversion. A company incurs expenses when it purchases inventory or receives a bill from a vendor, and it brings in revenue when it sells a product or service. These do not immediately involve cash if a company purchases on credit and extends credit to its customers. The cash cycle extends from the time companies pay their bills and suppliers through the time they receive cash payments for outstanding invoices from their customers. The shorter this cycle, typically the more cash the company consistently brings in.
Businesses can shorten a cash cycle by lengthening the amount of time its accounts payable remain outstanding. Specifically, the longer a company can extend its payment terms to pay for inventory, supplies and general expenses, the more it can shorten its cash cycle. If a company does not need to remit cash to pay its bills for 30 or 45 days, it has an extra 30 to 45 days to bring in cash from the sale of inventory or conversion of accounts receivable.
Companies can also shorten their cash cycles by turning over their inventory faster. The quicker a company sells its goods, the sooner it takes in cash from cash and credit card sales and begins its accounts receivable aging. Inventory turnover has no impact on the cash cycles of service companies with no inventory.
Accounts receivable conversion to cash has a significant impact on the cash cycle. Companies can shorten this cycle by requesting upfront payments or deposits and by billing as soon as information comes in from sales. Businesses can also shorten cash cycles by keeping credit terms for customers at 30 or fewer days and actively following up with customers to ensure timely payments.