Managing your company’s working capital can significantly improve its profitability and cash flow. A key metric of how efficiently a company manages its working capital is the cash conversion cycle; it reflects how long it takes from the time cash is paid to vendors, to the time cash is collected from customers.
Cash Conversion Cycle = Days Inventory + Days Receivable – Days Payable
Companies can unlock value when they minimize their cash conversion cycle by collecting receivables faster, carrying less inventory, and extending the time it takes to pay vendors.
Reducing a company’s cash conversion cycle by efficiently managing working capital not only leads to improved operating cash flow and increased profitability, but also increases a company’s enterprise value.
If you’re not familiar with the term, enterprise value is a figure that theoretically represents the entire cost to an investor to acquire 100 percent of a company. It’s calculated by adding a corporation’s market capitalization, preferred stock, and outstanding debt together and then subtracting the cash and cash equivalents found on the balance sheet.
For a small business, it’s important to note that when large companies decide to make improvements in their working capital, it often comes at the expense of their vendors . . . which could be you. In other words, whenever your customer wants to improve their own cash conversion cycle, they will extend payment terms and shorten inventory lead times which can negatively impact you: their vendor. You need to be aware of this possibility and take precautionary measures.
Regardless of the challenges you face, reducing the amount of time cash is tied up in working capital has proven to be an effective strategy to increase profitability and company value.