“Cash is oxygen for your business.”
A good friend texted and asked me for an example of the Cash Conversion Cycle that I mentioned in a previous column. My friend was right to ask. The CCC is a great concept that will help you maximize the cash in your business and your return on investment.
Companies that don’t grow die. It is impossible to keep great talent without growth. Growth eats cash but you must grow. What is a leader to do?
Maximizing your CCC is a requirement to growing your business with internally generated cash. This is the way Chick-fil-A did it and they are now debt-free. Growing with internal cash allows you to grow your business without external investors. This means you continue to control and own more of your business.
Let’s get into the math so you can see how fast you can grow your business with internal cash. The number we are working to improve is your Self-Financeable Growth Rate.
I am 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 in this article, please check it out.
Our example company is called Chullins Distributors. Grab a sheet of paper or an Excel spread if you’d like to follow along. Send me an email if you’d like a copy of my spreadsheet. We’ll use small numbers to keep the math easy.
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.
Those are all the inputs you will need to do a simplified version of the math. We are ignoring depreciation in this example.
Chullins’ customers pay their invoices in 70 days and inventory is held on average for 80 days before it is sold.
Accounts receivable days are calculated by taking the accounts receivable on the balance sheet ($384) and dividing it by daily sales ($2,000/365). Days inventory is calculated by taking the inventory on the balance sheet ($263) and dividing it by the daily cost of sales ($1,200/365).
Add the 70 days it takes Chullins to get paid to the 80 days that inventory is on hand before it is sold to get its Cash Conversion Cycle of 150 days. Thankfully, Chullins does not pay its suppliers the day their inventory arrives. It has 30-day terms with its suppliers so their cash is only out 120 days.
In addition to inventory and accounts receivable, we must account for the cash needed for everyday operating expenses like payroll, marketing, selling, utilities, etc. We’ll assume these are paid evening throughout the CCC. This would make these expenses out for an average of 75 days or half of the CCC.
Now that we know how long Chullin’s cash is tied up we need to determine how much cash is involved. Chullin’s gross margin is 40%, so we know that $.60 of every dollar of revenue will be tied up in costs of goods sold. That cash is out for 120 days of the 150 day CCC or 80% of the cycle. So, the average amount of cash needed for cost of sales over the entire cycle is $.48 per dollar of sales ($.60 x 80%).
Operating expenses are 35% of sales. Therefore, Chullins invests $.35 in operating expenses per dollar of sales. This money is out for 75 days of the 150 day CCC or 50% of the cycle. That results in $.175 of cash needed for operating expenses over the entire cycle – per dollar of sales ($.35 x 50%).
All in Chullins must invest $.655 ($.175 + $.48) per dollar of sales over each operating cash cycle.
Thankfully, Chullins is a profitable business. It generates $.05 of profit for every dollar of sales. That $.05 can be invested in working capital and operating expenses to generate more revenue in the next cycle. How much growth can Chullins afford?
Let's assume that Chullins decides to invest the entire $.05 of profit from every sale back into the business. We have to assume the market will allow the growth and that Chullins has the internal capacity to grow.
Adding $.05 to the $.655 investment already required increases investment by 7.63% (.05/.655). That translates into revenue growth of 7.63% every 150-day cycle. Chullins has 2.43 cycles per year (365/150). 7.63% x 2.43 yields a Self-Financeable Growth rate of 18.58%. Chullins can grow at the rate of 18.58% per year without running out of cash.
What if Chullins wants to grow faster than 18.58% per year? Then it must pull one of the three levers at its disposal to increase its SFG. Those levers are speeding cash flow, reducing costs and raising prices. We’ll show you the impact of each of those in our next column. If you made it this far, take a break. You deserve it!
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 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!).
