Cash to Cash Cycle

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Editors Note: This is the one in a series of articles that explains different financial indicators used to measure how efficientlya company is operating from a Lean perspective. Each article will explain the metric, its use, how to calculate it, what goodperformance on the metric is (or where you can locate current information on good performance), and what the pitfalls are inusing the metric. We look forward to your feedback on these articles and to your suggestions for which metrics we shouldaddress next.

Cash-to-Cash Cycle - Jacob J. Bierley, Jr., MBA

Contents

IntroductionThe Cash to Cash Cycle When is Cash Out of Reach?Cash to Cash and the ExtendedValue StreamHow to Compute Cash-to-CashCycle

ExampleDesired Results of Cash-to-CashCycleInterpreting Inventory Turnover

CautionsHow to Improve Cash-to-Cash CycleAbout the AuthorFeedback Please

Introduction

Lean views a business as a stream of value-addingactivities that culminate in satisfying a customers' realneeds. Key agents propel this stream. First and foremostof these are people. Their decisions and actions are thefundamental drivers of the value stream. Another isoperating equipment. Some equipment transformsmaterials into the finished offering the business deliversto its customers. Other equipment transfers the offeringsto the customer. A third factor that propels the valuestream is cash. Yes, cash is a factor that fuels valuestream activity. It is used to acquire and support activityby the other factors of production and, in that sense,shares in enabling their productivity. Like any of these factors, its availability for service constrains itsutilityi.e., when it is not available, it cannot be adding value and therefore is simply waste. Use theconcept of machine uptime as an analog for cash availability. If a machine is up, it can be put toproductive use. If it is down for maintenance or repairit is non-productive and thereby waste. Whencash sits locked up and out of reach such that it cannot be invested in activities that propel the valuestream, it too is non-productive and therefore waste.

How do you measure whether you are operating "lean" with regard to cash? And, how doesimplementing lean improvements free cash to be value adding?

Cash-to-Cash Cycle http://www.vitalentusa.com/learn/cash_to_cash.php

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The Cash-to-Cash Cycle

One way to detect how lean you are operating with regard to operating capitalthe funds available foruse in financing the day-to-day activities of a businessis to measure the length of the cash-to-cashcycle. The cash-to-cash cycle1 calculates the time operating capital (cash) is out of reach for use by yourbusiness. The speedier your cash-to-cash cycle, the fewer days your cash is unavailable for use inpropelling your value stream. You can use this metric to gauge whether you are operating "lean" withregard to cash. Also, good performance on the cash-to-cash measurement has been associated withimproved earnings per share (Ward, 20042).

When is Cash Out of Reach?

Your business's cash is out of reach when it is uncollected from customers and when it is soaked up byinventory that sits on the shop floor, in office storage areas, or on computer disks.

Uncollected payments are termed "receivables" and are reported on your business's balance sheet. Howquickly a receivable is registered and how long it sits uncollected is determined by your business'sorder-to-cash-receipt value stream.

Inventory is cash converted into materials and intermediate outputs that are not ready to benefit acustomer. Think of inventory as a cash absorbing sponge. As long as inventory sits, it holds your cashcaptive. How long it sits is a function of how well your supply chain and production value streams aresynchronized with customer demand. When these systems flow, are pulled by the customer, and free ofall wasteinventory is zero.

Cash to Cash and the Extended Value Stream

A neat feature of the cash-to-cash cycle is its ability to represent how efficiently the extended valuestream is operating (Exhibit 1, below). As you know, for an enterprise to be truly lean, it must apply leanthinking to improving the operations of both its suppliers and its customers as well as itself.3 For the flowof cash to be optimized,4 you need alignment and synergy across the extended value stream.

How to Compute the Cash-to-Cash Cycle

The cash-to-cash cycle is computed using the number of days that cash is invested in inventory plus thedays that your uncollected earnings sit as receivables less the days cash remains available to yourbusiness because your business has yet to pay its bills (e.g., for goods or services from its suppliers).


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This last element may seem odd since one typically thinks of debts as money spent and gone. But, inbusiness, just as in our personal lives, the longer a debt goes unpaid, the longer that cash remains withthe business (or us) and therefore available for use. This reverse benefit from not paying debts doescreate an opportunity to improve your cash-to-cash cycle in ways that are inconsistent with the leanmodeland we will discuss this below. For now, it should seem clear that the faster your business turnsover its inventory, the faster it bills and collects what is owed to it, and the slower it pays its debtsthebetter its operating cash position. Exhibit 2 presents how to compute the cash-to-cash cycle time.

Exhibit 2. How the Cash-to-Cash Cycle Is Computedfor a Given Reporting Period

Cash-to-Cash Cycle = + Days Cash is Locked-Up as Inventory + Days Cash is Locked-Up in Receivables - Days Cash Is Free Because the Business Has Not

Paid Its Bills

Think about this formula for a moment and it should make sense. The days a business's cash sitslocked-up as inventory, it is unavailable. Since these days extend the cash-to-cash period, add them.The more days the cash a business earns through sales is uncollected, the longer the cash remainsunapplied to adding value, so we add these days as well. On the other hand, the longer the businessholds on to its cash by not paying a debt it owes, the more cash it has to propel its value stream. Wetherefore deduct these days from the cycle to reflect that cash is available. Again, this last element has afunny ring to it because it suggests that it is to a business's benefit to drag its feet in paying what it owesor pressure vendors to accept longer and longer repayment period. And, as you can see from theformula, it will make the business look better on this metric.5 But, put that concern aside. For now, seehow this metric works. Exhibit 3 presents how to calculate each component that contributes to thecash-to-cash cycle time.

Exhibit 3. Components of the Formula Used to Computethe Cash-to-Cash Cycle

Component How to Calculate It Inventory

Days Cash isLocked-Up asInventory

Average DollarValue InventoryDuring theReporting Period

(Cost of GoodsSold)* /Number ofDays in theReportingPeriod)

ReceivablesDays Cash isLocked-Up inReceivables

Average DollarValue ofAccountsReceivableDuring theReporting Period

(Sales /Number ofDays in theReportingPeriod)

Unpaid BillsDays Cash Is FreeBecause theBusiness Has NotPaid Its Bills

Average DollarValue ofAccountsPayable Duringthe ReportingPeriod

(Cost of GoodsSold / Numberof Days in theReportingPeriod)

*Obtain the Cost of Goods Sold (COGS)6) for the reporting period from thebusiness's Profit/Loss statement for that period. If it is not available,compute the cost of goods sold (COGS) using the following formula: COGS= Dollar Value of Inventory at the Beginning of the Reporting Period + DollarValue of Purchases During the Reporting Period - Dollar Value of Inventoryat the End of the Reporting Period. "Purchases" refers to materials andsupplies bought for producing new outputs.


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Example

Exhibit 4 presents excerpts from the XYZ Business's Balance Sheet and Profit/Loss statement forJanuary 2006. All dollars are reported in units of a million.

Exhibit 4. Excerpts From XYZ's FinancialStatements

Information Jan 1 Jan 31 Balance Sheet Accounts Receivables $400 $600 Raw & Finished Goods

Inventory$500 $300

Accounts Payable -$300 -$100

Profit/Loss Statement Sales $1,000 Cost of Goods Sold -$ 700 Gross Margins $ 300

Using the information in Exhibit 4, we can compute XYZ'z cash-to-cash cycle time for January (Exhibit 5).

Exhibit 5. XYZ's Cash-to-Cash Cycle for the Period January 1 ThroughJanuary 31

Component Computation Result Inventory - Average

number of days= ($500 + $300 / 2) / ($700 / 31 days) = 17.70

Receivables - Averagenumber of daysuncollected

= ($400 + $600 / 2) / ($1,000 / 31days)

= 15.50

Days Cash Is FreeBecause the BusinessHas Not Paid Its Bills

= (-$300 + -100 / 2) / ($700 / 31 days) = -8.80

Cash-to-Cash Cycle (in days) 24.40

Based on this information, XYZ had its operating capital locked-up for 24.4 days before it becameavailable. The performance is less speedy when the effects of holding payments to vendors is extracted(33.2 days).

Desired Results of Cash-to-Cash Cycle

In a truly Lean system, there is no waste in any value stream. Goods are not manufactured or shipped tothe customer unless pulled and they are produced by production systems that flow continuouslywithout reliance on inventory. Raw materials are not acquired and processed unless a customerdemands a finished output. Customers are billed and pay immediately upon receipt of a purchasedproduct or service. In its ideal state, it is a just-in-time system from the origins of its supply chain throughto the receipt and payment by its customer. In this scenario, the lean producer also pays its suppliersupon receipt as its customers pay upon delivery. There are zero receivables, inventory, and payablesand thus a zero day cash-to-cash cycle time. Although a zero-day cash-to-cash cycle is truly Lean, yourbusiness approaches its best achievable state progressively by shortening the cycle times it initially


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displays.

Interpreting Cash-to-Cash Cycle

While a shorter cash-to-cash cycle is generally considered a positive indicator of operating leaner, youneed to look deeper to be sure. You can achieve shorter or even negative cycle times by means that areinconsistent with lean. As stated previously, you can shorten your cycle times by pressuring yourvendors to accept delayed payments for goods they deliver.7 With regard to longer cycles, someindustries have inherently longer lead times for accomplishing their value streams than other industries.If you build large complex outputs like warships or office towers for example, your business's cash willbe tied up longer than say for a business that is a computer systems integrator, like a Dell or Gateway,where they assemble their products in minutes.

To properly evaluate your cash-to-cash cycle performance, you need to analyze your cycle time inconjunction with other information. First, always assess it over time. The trend of your cycle time is morecritical than its value at a single point. Second, if you want to understand a point-in-time value, look tothe typical cash-to-cash cycle for other businesses in your industry.6 You always want to have fasterconversion cycles than your competitors. Third, before celebrating any apparent achievement incash-to-cash speed, make certain that you read and apply the cautions described below. Each explainsa way you can achieve fast cash turnaround that we would not perceive as worthy or smart from a leanperspective.

Cautions

1. Squeezing suppliers Some companies shorten their cash-to-cash cycle and can achieve negativecycle times by squeezing their suppliers to accept long payment periods. This is possible forcompanies that have size and great buying power relative to the vendors whose products or servicesthey purchase. The buyer uses its power to control its suppliers behavior. From a lean perspective,such control strategies corrupt the extended value stream by pitting components against each other.On a purely pragmatic level, such squeezing can undermine the viability of your suppliers and doundermine your supply relationships. Threatened and exploited suppliers are provoked to develop acounterbalancing force to offset your buying power. They will seek to dilute that power throughcommercial or political action that progressively erupts into full blown adversarial relationships.

Failsafe: A simple check is to obtain the computed value for the "Days Cash Is Free Because theBusiness Has Not Paid Its Bills." In the example presented in Exhibit 4, above, the number isnegative. The ideal value from a lean perspective is actually zero (0). You can also request fromaccounting an aged payables report. This report will show you the distribution of payables by varioustime periodse.g., 30 days, 31 to 45 days, 46 to 60 days, over 60 days. Almost all payables shouldbe under 45 days in age. If you note that 10% or more of the payables are unpaid for longer than 45days, then consider yourself as using your vendor's cash to augment your operating capital.

2. Verify Turnover Success Is Due to Lean Improvements - Before celebrating a reduction in yourcash-to-cash cycle time due to reduced days of inventory, make sure your inventory success resultsfrom being truly lean. Use the guidance in the article Inventory Turnover to make this judgment. Youneed to analyze your improvement with inventory in conjunction with other trends within your financialstatements to ensure that your operations are truly business beneficial. For example, you can getapparent improvements in inventory management by advanced sales, phantom sales, or discount-driven sales. Advance sales cause a point-in-time improvement that reverses in the very nextreporting period. The other two methods actually harm your business. Also, you can produceimproved inventory results by applying control strategies that force customers to take finishedproducts before they need them.

Failsafe: Use the guidance in the section Interpreting Inventory Turnover, to verify that your successwith reducing the days of inventory your business maintains is due to the effective application of leanthinking.


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How to Improve Cash-to-Cash Cycle

To improve your cash-to-cash cycle, begin internally. Start by reducing your inventory and increasinginventory turnover. This will speed the cash-to-cash cycle. In parallel, Kaizen your order-to-cash-receiptwork processes. Speed the invoicing process, reduce billing errors, speed response to overdue bills, andreduce the incidence of bad debts. As your cycle time and error rates come down, cash becomesavailable to enable timely payment of your suppliers and redeployment in your business. Next, develop asupply chain that reliably provides you exactly what you need, just when you need it, with the leastwaste incurred on the part of your suppliers and your business. This will minimize both inventory and thecash you need to spend for the inputs you require.

Remember, as you pursue perfection, be certain to implement improvements that benefit all members ofthe extended value stream. Lean requires inclusive thinking so that optimization of one component doesnot create waste or diminish value in another component.

About the Author

Jacob J. Bierley, Jr. received both his MBA in Finance and BS in Accounting from Indiana University'sKelley School of Business. He has 14 years in auditing and accounting management. Mr. Bierley iscurrently the Controller for Bunge Oils for Bunge North America where he coordinates all aspects ofaccounting controls, practices, processes, and policies in support of Bunge Oils. Bunge North America isa primary supplier of high-quality agricultural commodities and value-added, specialized food and feedingredients and food products to the global marketplace.

Footnotes

1Also referred to as the "cash conversion cycle."

2Ward, Peter (2004) Cash-to-cash is what counts. Journal of Commerce, February 16, 2004. Available online at:www.hitachiconsulting.com/downloadPdf.cfm?ID=57.

3Womack, James P. and Jones, Daniel T. (2003) Lean Thinking. (Revised and Updated) New York, NY: Free Press, page 327.

4Optimizing the cash-to-cash cycle time from a lean perspective has a different meaning than from a traditional producer-focused perspective. In a lean perspective, optimum sustained competitive advantage comes from working interdependently withyour suppliers and customers. In a producer-focused competitive strategy, advantage is believed to result from controlling thebehavior of suppliers and customers to advantage your business. For example, given the opportunity, you would force vendors toaccept longer payment periods so they, in effect, extend your business interest free loans. Also, you would use marketcontrolling methods to restrict customer choicese.g., advocating for tariffs on the offerings from competitors.

5From a lean perspective, benchmarking can be a distraction as your intent is perfection, not just performance better than yourcompetitors. Nonetheless, if you need to evaluate a point-in-time value, comparison to a benchmark is needed. If possible,consider industry average, best in class, and world-class benchmarks. Ward (2004) offers some benchmarks based on hisresearch. Ward reports the following cash-to-cash cycle times: For "Tier 1" automotive companies - 40 days; heavy industrycompanies - 200 days; consumer goods sector between 50 and 150 days; and supermarket chains - 10 to 35 days.

6There are alternatives to using COGS is this computation. For example, one might use Annualized Materials Cost as asubstitute. Neither is ideal. Both metrics have a degree of distortion in them. COGS inflates payables to suppliers by includingthe cost of goods and services supplied internally. On the other hand, annualized materials cost deflates payables to suppliersby not including the cost of contracted services (e.g., personnel, utilities, other services). In some industries, these non-materialsupplier costs are a great deal of money. So, each has a degree of distortion and the distortion varies by industry. The idealwould be segmenting payables by supplier type so that employee labor, for example, might be extracted and a "pure" andcomplete externally sourced cost computed. I like COGS because it allows you to compare cash cycle metrics betweendifferent companies and industries. Also, COGS is a commonly reported item in financial reports, whereas material cost may notalways be reported as it is a subset of COGS. If you have a choice within your company as to which metric to use, I suggestselecting the metric that reliably provides you the most accurate information about all your supplier payables.


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Documents

Cash to Cash Cycle