“Revenue is vanity, profit is sanity, but cash king!”
Last week, we showed you how to calculate the Cash Conversion Cycle for your business. This week we want to explore the impact of three levers to improve your CCC.
We are using an example provided by Neil Churchill and John Mullins in a Harvard Business Review article titled “How Fast Can Your Company Afford to Grow?” To grab more detail than I can go into here, please check out their article at HBR.org.
Our example company is called Chullins Distributors. Grab a sheet of paper or an Excel spread if you’d like to follow along. Here are the details on Chullins.
Chullins has sales of $2,000, costs of goods sold of $1,200 and operating expenses of $700. This results in a gross margin of 40% and a net profit of 5% or $100.
On Chullins balance sheet, it has cash of $10, accounts receivable of $384, inventory of $263 and plant and equipment of $25 for total assets of $682.
It has accounts payable of $99, bank loan payable of $50 for total current liabilities of $149. There is contributed capital of $350 and retained earnings of $183.
Last week, we determined that Chullins has a Self-Financeable Growth rate of 18.58%. That means that it can grow sales 18.58% per year without running out of cash. What if they want to grow faster? They’ll need to improve their SFG by using one of three levers: Speeding Cash Flow, Reducing Costs or Raising Prices. Let's look at the potential impact of each lever.
Speeding Cash Flow: Let's say that Chullins’ management could reduce their accounts receivable days from 70 to 66 through better accounts receivable management. Also, assume management can reduce its inventory turns from 80 to 74 days through better forecasting.
These changes reduce their CCC from 150 to 140 days. The company still spends $.60 in cost of sales for every dollar of revenue. But the $.60 is tied up for only 110 days out of 140 (rather than 120). This reduces the cash needed for inventory over the entire cycle from $.48 to $.471.
Now the company needs $.646 to generate one dollar of revenue per cycle compared to $.655 before the improvements. This improves Chullins SFG rate per cycle to 7.73%. Since the CCC has decreased, there are now 2.606 cycles per year instead of 2.43. 2.606 x 7.73% results in an annual SFG of 20.15% vs. 18.58% before the improvement. Not bad for slight improvements to accounts receivable and inventory days.
Reducing Costs: What if Chullins’ management could reduce the cost of sales from 60% to 59% and trim operating expenses from 35% to 34.5% of sales. This would reduce the cash needed to finance the next cycle from $.655 to $.6445 and raises profit from 5 cents per dollar of revenue to 6.5 cents.
This allows Chullins to generate 10.09% more sales in the next cycle which results in an annualized SFG rate of 24.54% vs. their original SFG of 18.58%.
Raising Prices: I know we all wished we could raise prices at any time but the resistance to higher prices can be more internal than external. What if management believes it could raise prices by 1.5% and not reduce demand? That would result in an SFG of 24.15%. A tad lower than the SFG achieved by reducing costs because reducing costs allows for slightly more cash to be reinvested per CCC.
Here is the takeaway. Very small changes to the operational dynamics of your business can have dramatic impacts on your ability to self-finance growth. Give me a call if you’d like to use my spreadsheet to do the math for your company.
We love helping leaders build great businesses. If you’d like to learn more you can check out our free resources at www.valuesdrivenresults.com/resource-library/ or give us a call at (229) 244-1559. We’d love to help you in any way we can.
Curt Fowler is president of Fowler & Company and director at Fowler, Holley, Rambo & Stalvey. He is dedicated to helping leaders build great organizations and better lives for themselves and the people they lead.
Curt and the team at FHRS help leaders build great companies through Virtual CFO, strategy, tax and accounting services.
Curt is a syndicated business writer, keynote speaker, and business advisor. He has an MBA in strategy and entrepreneurship from the Kellogg School, is a CPA and a pretty good guy as defined by his wife and four children (No. 5 coming June 2021!).
