How to Optimise Your Cash Conversion Cycle to Improve Your Business Liquidity

Managing payroll, supplier payments, and unexpected expenses (all the while waiting for customer payments to come through) is a daily struggle for CEOs and CFOs in South Africa.

To stay afloat, you must take action to optimise your cash conversion cycle (CCC). This metric tracks how quickly you turn your investments into cash, and improving it means better business liquidity and fewer financial headaches.

Jump to the important details:

What is the Cash Conversion Cycle?

The cash conversion cycle (CCC) is a financial metric that measures the time it takes for your company to convert its investments in inventory and other resources into cash flows from sales. It encompasses three components:

  • Days Inventory Outstanding (DIO): The average number of days inventory remains in stock before being sold.
  • Days Sales Outstanding (DSO): The average number of days it takes to collect payment after a sale is made.
  • Days Payable Outstanding (DPO): The average number of days your company takes to pay its suppliers.

To calculate your CCC, follow this formula: CCC=DIO+DSO−DPO. A shorter CCC indicates that your company is quickly converting its investments into cash; that’s what every business wants to see, but it’s not always the reality.

Signs You Need to Optimise Your Cash Conversion Cycle

If your business frequently struggles to cover payroll or operational expenses despite steady sales, it may indicate that your Days Sales Outstanding is too high. This scenario highlights the need to optimise the CCC.

Consider the following signs, as well:

  • High Inventory Levels. Excess inventory can tie up cash that could be used elsewhere, suggesting a high Days of Inventory Outstanding.
  • Delayed Supplier Payments. Regularly delaying supplier payments can harm relationships and disrupt the supply chain. This points to an inefficient Days Payable Outstanding.
  • Increasing Borrowing Needs. Frequent reliance on short-term loans to bridge gaps in cash flow can be a red flag. This reliance on external financing, with associated interest costs, suggests inefficiencies in the CCC.
  • Missed Growth Opportunities. A lack of liquidity can lead to missed opportunities during peak seasons.
  • Stagnant or Declining Profit Margins. Even with increasing sales, stagnant profit margins can signal issues with the CCC. A food processing business might experience this if it has a high DIO due to overstocked raw materials and high DSO from delayed customer payments.
  • Poor Financial Health Indicators. Indicators such as a low current ratio and quick ratio can reveal poor liquidity management.
  • Customer Complaints About Payment Terms. Rigid payment terms that don’t align with customers’ cash flow cycles can delay payments and damage relationships.

Tip One: Improve Inventory Management

Getting your inventory in check is key to lowering DIO. Start by using just-in-time (JIT) inventory systems to cut down on excess stock and save on holding costs. Use demand forecasting tools to predict sales trends, so you can keep your inventory at the right level.

It’s also important to regularly check your inventory turnover rates to spot slow-moving items, which you can discount or bundle to clear out. For example, a small electronics shop might use a JIT system to match inventory with seasonal demand, avoiding a pile-up of outdated gadgets.

Tip Two: Streamline Accounts Receivable Processes

Reducing DSO means tightening credit policies and speeding up collections. Automated invoicing systems ensure timely and accurate billing, cutting out delays from manual errors (and saving your team precious time).

A software-as-a-service (SaaS) company might use automated billing to send invoices right after service delivery and follow up with reminders, which speeds up their payment cycle.

Tip Three: Extend Payment Terms with Suppliers

Try negotiating longer payment terms with your suppliers to optimise DPO. This will allow you to hold onto cash longer, improving liquidity without upsetting supplier relationships. Keep communication open and be reliable with payments. Look into supplier financing options like trade credit to help manage cash flow.

Tip Four: Utilise Technology and Automation

Financial software that integrates inventory, billing, and payment processes can cut down on manual errors and save time. Business intelligence tools can analyse CCC metrics and highlight areas for improvement. Altogether, these technologies streamline your CCC. As for automation, it speeds up your operations and provides real-time data for better decision-making.

Tip Five: Implement Vendor Managed Inventory (VMI)

VMI can significantly cut your DIO by letting suppliers manage your inventory levels based on real-time sales data. This keeps stock levels optimal without stressing your cash flow. VMI can boost supply chain efficiency and reduce the hassle of inventory management.

For example, a supermarket chain might partner with suppliers to implement VMI to ensure shelves are always stocked with popular items without excessive overstock.

Tip Six: Regularly Review Credit Policies

Align your credit policies with your cash flow goals and review them regularly to ensure they remain effective. Assess customer creditworthiness periodically and adjust credit limits as needed. Implement stricter credit terms for high-risk customers and consider requiring deposits or partial payments upfront.

Clear and consistent credit policies help reduce DSO and maintain steady cash flow. For example, a construction company might tighten credit terms for new clients by requiring a 30% deposit to minimise the risk of non-payment.

Tip Seven: Optimise Order-to-Cash Cycle

Streamlining the order-to-cash process can help reduce payment delays. Ensure accurate order entry, efficient processing, and timely invoicing. Integrate sales and finance systems for greater visibility into order status and payment tracking. This big-picture view plays a role in optimising your CCC.

An online retailer might integrate its e-commerce platform with accounting software to ensure orders are processed and invoices sent out immediately, thus speeding up its cash conversion process.

Tip Eight: Improve Demand Planning

Accurate demand planning helps balance inventory levels, reducing the risk of stockouts or overstocking. Use historical sales data and market trends to forecast demand accurately. Collaborate with sales and marketing teams to anticipate changes in demand and adjust inventory levels proactively.

Consumers and the economy are volatile variables – as businesses, we must plan for the unexpected, as our revenue hinges upon it.

At Merchant Factors, we offer Bridging Finance to give you quick access to funds, bridging the gap between receivables and payables and helping you maintain a healthy CCC.

Contact our team for more information. We look forward to discussing your needs.