Why Your Cash Conversion Cycle is Crucial During Inflationary Times
April 28, 2021 |
The C2FO Team
The economic rebound is fueling global concerns about inflation. Here’s how priming your cash conversion cycle can help your company respond to and pivot during an inflationary period.
There’s been a lot of talk about inflation in recent months. And with good reason.
If you’re too young to remember, “inflation” and “hyperinflation” were scary terms back in the late 1970s and early ‘80s, when interest rates rose to nearly 20% and the average inflation rate was 6.8%.
Well, inflation appears to be making a comeback primarily due to the amount of spending by governments and central banks over the past year to help individuals and businesses affected by the coronavirus pandemic.
In 2020 and 2021, governments have poured money into the global economy to stabilize it during the pandemic. In the United States alone, the monetary base, from which dollars are created, increased 50% in the past 12 months, while the actual stock of money increased 26%.
A recent survey of economists by The Wall Street Journal found their average forecast for US economic growth in 2021 to be 6.4% — which would make it one of the fastest-growing years in the past seven decades. In March, the US Labor Department’s Consumer Price Index rose 2.6%, which is the biggest 12-month increase since 2018. In Europe, inflation rose 1.3% in March from the previous year, up from 0.9% in February. Further lockdown measures throughout Europe due to COVID-19 could put additional upward pressure on prices.
Economic growth is good. But growth on this scale creates a ripe environment for inflation to rise over the next two years.
How can your company combat this? 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.
Surges in pricing
Economists worldwide have grown concerned about an inflationary cycle because of a recent increase in commodity prices. In March, China’s Producer Price Index increased by the greatest percentage since 2018, rising 4.4% over the previous year after only a 1.7% gain in February.
Meanwhile, the costs of oil, copper and agricultural goods have rallied since the depths of the pandemic. The world’s leading suppliers of semiconductors are trying to overcome a prolonged chip shortage, which affects pricing on high-demand products ranging from laptop computers to home appliances to automobiles. C2FO analysts have seen this trend happening at scale through data trends on the C2FO platform. Last year, payables showed a 27% increase in spending on specialized semiconductors and a 47% increase in spending on network chip categories.
On a global scale, an economic rebound fueled by massive stimulus programs like the recent $1.,9 trillion spending package in the US has contributed to a rise in shipping prices. As the world’s largest exporter, China’s rising prices threaten to spread inflation around the world.
These trends, when combined with a pandemic that is still not under control, mean continued stress and uncertainty for suppliers of all sizes. Fluctuating demand and COVID-19 lockdowns still make it incredibly difficult to predict and manage inventory levels, especially in the retail sector. Many suppliers find themselves squeezed between later payments from customers trying to preserve cash and rising cost-price inflation.
There is a way to ease that pressure, however. It involves shortening your company’s cash conversion cycle.
How a cash conversion cycle works and how to speed it up
When it comes to growing your business or responding to unexpected market conditions, cash is obviously king. Therefore, CCC is one key metric used to evaluate the efficiency of a company’s operations and management. It measures how long it takes to convert investments in inventory and other resources into cash flows from sales.
CCC accounts for:
- How much time your company needs to sell its inventory
- How much time it takes to collect receivables
- How much time you have to pay your bills without incurring penalties
Another simple way of thinking about CCC is through this mathematical formula:
CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
Improving CCC requires improving one or more of its three components: reducing DIO, reducing DSO, or increasing DPO.
The events of 2020 and the continued uncertainties of 2021 have motivated companies to take a closer look at all three parts of their CCC. Before the pandemic, improving DSO and DPO were not priorities and were more along the lines of “nice to haves” for many companies. Now, they are necessities. Reducing days inventory outstanding (DIO) has been particularly important, as many companies’ supply chains were woefully unprepared for the events of 2020.
A high DSO indicates trouble with collecting on receivables — not an uncommon challenge during the pandemic. Early payment on the C2FO platform can help reduce DSO, increase cash flow and therefore shorten a company’s CCC. With C2FO’s early payment, suppliers have the flexibility of choosing which customer invoices to accelerate payment on at rates that work for them.
The quicker your company can collect on receivables, the shorter your CCC becomes. Since 2010, C2FO has helped companies reduce their collection times — and improve DSO — by an average of 31 days.
Why is CCC important in combating inflation?
When commodity inflation hits, the money you have loses value relative to the commodities your company needs to purchase. That’s why speeding up your CCC can be beneficial right now.
For example, 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.
Whether your company purchases lumber or semiconductors or grain, you’ll want the money from your accounts receivable to come in rapidly so you can turn around and buy more of that inventory. Because next week, and the weeks that follow, the price for that inventory will increase.
Passing on increased costs to your customers may not be an option, said Srishti Chhabra, C2FO’s VP of Operations for EMEA.
“Increasing prices with buyers will be a lot harder to negotiate,” she said. “Suppliers should try to lock in prices to avoid being priced out of the market.”
The bottom line
Disco and lava lamps may never make a comeback. Hopefully, the hyperinflation of the late 70s and early 80s won’t either.
However, it’s important to pay close attention to how inflation is affecting commodity prices worldwide and to make sure you have the cash on hand to shorten CCC, reduce DSO and lock in purchases now before costs spike.