Cash to cash cycle definition
/What is the Cash to Cash Cycle?
The cash to cash cycle is the time period between when a business pays cash to its suppliers for inventory and receives cash from its customers. The concept is used to determine the amount of cash needed to fund ongoing operations, and is a key factor in estimating financing requirements. You should have a firm understanding of the cash to cash cycle when constructing a budget, in order to properly estimate when additional funding will be needed.
The calculation is especially useful when there are indications that payment or receipt intervals are likely to change, so that one can estimate the impact on cash. It is also useful when attempting to recover a business from a bankruptcy situation, where cash is in short supply. A further use is when the cost of debt is high, and management is looking for alternatives that will require less outside funding. Yet another use is when investors want a dividend distribution, and management needs to extract cash from operations in order to make this payment.
How to Calculate the Cash to Cash Cycle
The cash to cash calculation involves adding together the days of inventory on hand and the days of sales outstanding, and then subtracting the number of days of payables outstanding. The formula is:
Days inventory on hand + Days sales outstanding - Days payables outstanding
= Cash to cash days
Related AccountingTools Courses
Financial Forecasting and Modeling
Example of the Cash to Cash Cycle
The inventory held by a business averages being on hand for 40 days, and its customers usually pay within 50 days. Offsetting these figures is an average payables period of 30 days. This results in the following cash to cash duration:
40 Days of inventory + 50 Days sales outstanding - 30 Days payables outstanding
= 60 Cash to cash days
This outcome states that a business must support its expenditures for a period of 60 days.
How to Shorten the Cash to Cash Cycle
Examination of the components of cash to cash cycle calculation might lead management to take several actions to reduce the duration of the cycle, such as the following:
Negotiate better supplier payment terms. Extending payment terms with suppliers (e.g., from 30 to 60 days) allows a company to hold onto its cash longer. This improves liquidity and reduces the need for short-term financing. Negotiating discounts for early payments can also be beneficial if cash flow permits.
Reduce inventory levels. Holding excessive inventory ties up cash that could be used elsewhere. Implementing just-in-time inventory management ensures that materials arrive only when needed, reducing storage costs and improving cash flow. Regularly analyzing inventory turnover rates helps maintain optimal stock levels.
Speed up customer payments. Encouraging customers to pay faster reduces the accounts receivable period. Businesses can offer early payment discounts or implement automated invoicing and online payment options to accelerate collections. Setting clear payment terms and following up on overdue invoices promptly also helps.
Improve invoicing processes. Delays in sending invoices result in slower payments and extended cash cycles. Using electronic invoicing (e-invoicing) ensures faster delivery, reduces errors, and allows for quicker dispute resolution. Automating invoice reminders helps keep payments on track.
Use factoring. Businesses can sell unpaid invoices to a factoring company at a discount to get immediate cash. Alternatively, invoice financing allows companies to borrow money against outstanding invoices. Both methods provide liquidity without waiting for customers to pay.
Streamline production and order fulfillment. Faster production and delivery mean customers receive products sooner, allowing invoices to be sent and paid earlier. Lean manufacturing and process automation can reduce delays and inefficiencies. This shortens the overall cash conversion cycle and improves working capital.
Increase sales forecasting accuracy. Poor demand forecasting can lead to either excess inventory (tying up cash) or stockouts (delaying revenue). Using data analytics and historical trends helps predict demand more accurately, reducing unnecessary inventory purchases. Better forecasting leads to optimized inventory and quicker cash turnover.
Implement supplier consignment agreements. With consignment inventory, suppliers retain ownership of stock until it is used or sold. This means businesses do not have to pay for inventory upfront, freeing up cash. It also reduces the risk of holding unsold inventory.
Adopt a prepayment model. Encouraging customers to pay before receiving goods or services improves cash flow. Businesses can offer subscriptions, pre-orders, or milestone-based billing to secure payments earlier in the cycle. This approach ensures revenue is collected ahead of costs.
Optimize logistics. Delays in receiving materials or shipping products extend the cash-to-cash cycle. Improving supplier relationships, using faster shipping options, and investing in supply chain technology can reduce lead times. A more efficient supply chain ensures quicker product delivery and faster customer payments.
By implementing these strategies, businesses can shorten their cash-to-cash cycle, improve liquidity, and reduce reliance on external financing.
Terms Similar to the Cash to Cash Cycle
Cash to cash is also known as the cash conversion cycle.
Related Articles
The Difference Between Cash Flow and Free Cash Flow