10 financial concepts you should master
Here is lesson seven in unwrapping essential financial concepts and how they will help you run your business.
The cash cycle
The cash cycle, also known as the cash conversion cycle, looks at how long it takes to convert money used to buy inventory sales to cash in the bank.
The cash cycle formula is simple and works off three elements – the accounts receivables in days, the accounts payables in days and the days that stock sits in inventory before it is sold. This is important because it tells us the number of days a company’s cash is tied up within the operations of the business and how well the business is managing its working capital.
There are business owners who make the mistake of ignoring the cash cycle and they do so at their peril. They will focus on revenues and expenses to manage cash flow but it’s the cash conversion cycle that can make or break the business.
As long as the inventory is not converted into sales it holds cash captive. The cash conversion cycle is the force that can create the cash crunch for any business.
Let us say, for example, a business is carrying items in inventory for 100 days. An item is sold on account, which will be settled in 60 days time but the business is paying creditors at 30 days, so the business has a cash conversion cycle of 130 days.
That could be a problem because the business has to fund that 130-day gap.
When there is too big a gap a business can “grow itself broke” and as sales keep growing it has to keep funding that gap. It is paying its suppliers but there is not enough cash coming in because it is tied up in inventory sitting on the shelves.
Cash tied up is like a piece of machinery that’s out of action for maintenance and can’t be put to any productive purpose.
The longer the cash is tied up the less it can be free for other uses such as investing in new capital, spending on equipment and infrastructure or meeting short-term expenses of the business. The cash conversion cycle needs to be as low as possible.