Inflation Is Here to Stay — Why Your Cash Conversion Cycle Will Be Key for Your Business
December 30, 2021 |
The C2FO Team
Following months of concern over the rapid rise in inflation rates, the Federal Reserve recently provided long-awaited clarity on how it would address this issue.
With a significant reduction in its monthly bond purchases and an indication of as many as three interest rate hikes in 2022, the Fed is now acknowledging that inflation is by no means “transitory” and that it believes it must act in order to counteract the situation. The recent rise in inflation has also significantly impacted the cost of doing business. The Fed’s aggressive position means that organizations of all sizes will soon feel the pressure of not only rapidly increasing interest rates, but also the reality of persistent inflation and an ongoing supply chain crunch driven by both material and labor shortages.
We here at C2FO have known for some time that rates would eventually be raised and recently provided our views on how businesses can prepare. Additionally, data gathered from the C2FO platform confirm that businesses are feeling the crunch and seeking alternative avenues to help alleviate the pressures these new costs create. Our data show a notable increase in average unique invoice totals in our marketplace. Between November 2020 and 2021, the average invoice value on the C2FO platform increased 11.7%, paralleling the November U.S. producer price index, which was up 9.6% over the same time period. We believe these numbers reflect the inflationary pressures that businesses face.
These combined challenges can be especially daunting to small businesses with fixed working capital positions. Businesses will face elongated supply chains that in turn will lead to longer cash conversion cycles (CCCs). Increased CCC coupled with a fixed working capital position leads to businesses facing not just reduced cash flow, but reduced revenue. Against this backdrop, businesses must recognize the reality of the situation and determine what options they have both internally and through trusted financial partners.
In our opinion, inaction is not an option. We see two primary solutions for businesses to maintain their margins and revenue. The most obvious is price increases, which businesses should be in the process of implementing and which our data show as discussed in the previous paragraphs. A second potentially overlooked solution, however, comes through a heightened focus on increasing working capital, specifically through a concerted focus on collecting cash on outstanding invoices as early as possible.
Consider the impact extended shipping times could have on the average business, especially as it deals with high inflation and increasing borrowing costs. In our simplistic example, in 2019, business “ABC Inc.” had a CCC of 120 days with 60 days accounts receivable (AR) outstanding, 90 days of lead time from manufacturer to its customers and 30-day terms from its manufacturer (120 = 90 – 30 + 60). Inflation was 2%, and ABC Inc. had a profit margin of 10%.
In 2022, with inflation likely to be 6%-7%, ABC Inc. will be faced with a considerable challenge to maintain its profit margin due to inflation and a longer conversion period brought on by supply chain issues. Let’s say that if nothing is done, ABC Inc.’s CCC goes from 120 days to 180 days, which means its profit margin will slip to about 7.5% (i.e., 10% - [7%-2%]/[365/150]) as ABC Inc. has exposure of 180 days from when it contracts with its customers to when it delivers. This would mean a 25% reduction in profit — because inflation will eat a net 2.5% over the CCC in excess of 2019 inflation.
Of course, businesses can and should adjust prices monthly, but ABC Inc.’s profit margin would still slip due to the elongated time it takes to order, process and collect.
However, just because inflation and supply chain challenges exist does not mean a business must accept a reduction in profit and a limited future upside. In fact, if ABC Inc. can maintain its CCC at 120 days by bringing AR days from 60 to 0, while at the same time adjusting prices, it can effectively maintain its profit margin of 10%. The effect of this is that despite the outsized challenges, it will see no reduction in profit.
C2FO is one of the fastest and easiest ways to reduce your CCC, and therefore, is paramount to managing the combined threats of inflation, supply chain challenges and rate increases. Each day, C2FO accelerates payment (i.e., reduces days sales outstanding) on outstanding invoices for its network of businesses, which reduces CCC for businesses like yours through our Early Payment working capital marketplace and Capital Finance products.
In November 2021, C2FO customers received $5.6 billion in funding through more than 3 million invoices accelerated through our marketplace. You too can accelerate invoices for below-market rates to turn cash over more quickly and achieve a return on equity of two to 10 times the cost of accelerating invoices. By working with C2FO and utilizing our Early Payment and Capital Finance products, your company could see an outsized return on equity.