Why Your Cash Conversion Cycle is Crucial During Inflationary Times
July 22, 2022 |
The C2FO Team
As inflation rises, tightening your cash conversion cycle can provide a buffer against increasing commodity costs. Here's how.
In the United States and around the world, inflation is hitting record levels and is projected to soar even higher. This has largely been attributed to increased consumer demand due to an early economic rebound from the COVID-19 pandemic and the Russian invasion of Ukraine.
To slow the pace of inflation, in 2022 central bankers across the globe have enacted a number of interest rate hikes. Despite these efforts, inflation is still on the rise. In June, the Consumer Price Index indicates prices have risen 8.6% from a year ago, resulting in the fastest increase since December 1981, according to a report from the US Bureau of Labor Statistics.
Of course, this has fueled concerns of a recession as businesses and consumers alike are faced with record-breaking price increases. As business owners, it’s important to be agile and ready to pivot in uncertain times. Increased costs due to supply chain shortages and inflation can significantly impact working capital and ultimately your bottom line.
So, how can your company lessen the impact of inflation? One way is by tightening your cash conversion cycle (CCC) and bolstering your cash flow, allowing you to spend now on commodities and products for your business that may increase in cost in the coming months.
Ongoing economic uncertainty
Economists worldwide remain concerned about the impact of inflation on commodity prices. Despite being over two years into the pandemic, there are still significant issues impacting the global supply chain.
Strict COVID-19 lockdowns in China continue to delay shipments of finished goods for retailers and intermediate goods for US manufacturers. In addition to this, the war in Ukraine is impacting gas and commodity shipments. These challenges, when combined with a contract dispute between the International Longshore and Warehouse Union and the Pacific Maritime Association, which has the potential to disrupt West Coast ports, mean continued stress and uncertainty for businesses of all sizes.
Fluctuating consumer behavior and looming disruptions make it incredibly difficult to predict and manage inventory levels, especially in the retail sector. Many businesses find themselves squeezed between later payments from customers trying to preserve cash and rising cost-push inflation.
In fact, a recent survey from MetLife and the US Chamber of Commerce found that 85% of small business owners expressed concern about inflation and 67% have raised prices in response to inflation pressure. Fortunately, there is a way to ease the pressure — by accelerating your company’s cash conversion cycle.
What is a cash conversion cycle, and how does it work?
When it comes to growing your business or responding to unexpected market conditions, cash is obviously king. The cash conversion cycle, also known as the net operating cycle, is an important metric for you to measure and understand. So what is it and what does it track?
It is a key metric used to evaluate the efficiency of a company’s operations and management. Specifically, it’s a measure of how long it takes you to convert investments in inventory and other resources into cash flow from sales.
The CCC accounts for:
- How much time your company needs to sell its inventory.
- How much time you take to collect receivables.
- How much time you have to pay your bills without incurring penalties.
Another simple way of thinking about the CCC is through this mathematical formula:
CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
How can you speed up your cash conversion cycle?
To speed up your cash conversion cycle, you need to improve one or more of its three components: reduce DIO or DSO, or increase DPO. For example, if you have not prioritized reducing your DIO and DSO before, it’s important for your business to do so now.
Shortening the number of days in the cash conversion cycle is one way you can alleviate the impact of inflation and ensure sufficient cash flow. The strategy is to sell inventory quickly, collect revenue promptly and pay bills slowly. Here are three actionable steps you can take to shorten your cash conversion cycle:
1. Invoice quicker.
You can reduce DSO, and in turn your conversion cycle, by improving your invoicing processes. To do so you need to have a reliable system in place, and generate and distribute invoices as soon as possible.
2. Provide incentives to your customers for faster payment.
Early payment platforms like C2FO's can help you to reduce DSO, increase cash flow and therefore shorten your cash conversion cycle. For example, with C2FO you have the ability to choose which invoices to accelerate payment on at rates that work for your customers.
The quicker your company can collect on receivables, the shorter your conversion cycle becomes. Since 2010, C2FO has helped companies reduce their collection times — and improve DSO — by an average of 31 days.
3. Pay your invoices no earlier than the due date.
You can preserve cash flow by optimizing your accounts payable practices to ensure your own payables are paid on time rather than early. By increasing the length of accounts payable outstanding, you give yourself more time to receive payments and shorten the cash conversion cycle.
Gaining a buffer against inflation
When commodity inflation hits, your money loses value relative to the commodities your company needs to purchase. If you had a crystal ball and could determine that a dollar would be worth 20% less in 60 days, you would likely want to collect that dollar as soon as possible so you could spend it before it loses value. That’s why speeding up your cash conversion cycle can be beneficial right now.
Whether your company purchases lumber, semiconductors or grain, you’ll want the money from your accounts receivable to come in rapidly so you can quickly buy more inventory. Next week, and the weeks that follow, the price for that inventory will increase, and passing on increased costs to your customers may not be an option.
Srishti Chhabra, C2FO’s vice president of operations for the EMEA region, says, “Increasing prices with buyers will be a lot harder to negotiate. Suppliers should try to lock in prices to avoid being priced out of the market.”
The bottom line
This means paying close attention to how inflation is affecting commodity prices worldwide and making sure you have the cash on hand to shorten the cash conversion cycle, reduce DSO and lock in purchases now, before costs increase even further. Ready to take control of your cash flow and optimize your cash conversion cycle? Discover how early payments can help you get ahead of inflation.
This article was updated on July 22, 2022, and was originally published in November 2020.