Understanding how your money flows through the business is important to the success of the business. Here is a lesson that help business owners manage cash before it slips through their fingers.
For every business money flows through the cash wheel. Starting as cash it then turns into inventory. For a retailer, inventory is the product on the shelves or in the warehouse. For a hotel, inventory is room nights. For a restaurant, it is raw food. For a service business, it is billable hours.
Then Inventory turns into Accounts Receivable (A/R). This is the time between the purchase and when you receive the cash in your bank account. If your business invoices customers, it is the time from when the invoice is sent and the check is received. That can be 30 to 90 days. For a retail business, this can be the float between the purchase and when the merchant bank pays your bank account.
Defining Inventory and A/R in days makes it easier to understand how long it takes to turn these back into cash. For example: You have $1,200,000 in annual sales, cost of goods sold of $500,000, hold $100,000 in Inventory and $250,000 in A/R.
Your Inventory turns would be Cost of Goods Sold / Average Inventory for a product based business or Sales / Inventory for a service business. In our case, that would be $500,000/$100,000 = 5 turns. Inventory would turn 5 times a year. To turn that into days, take (1 / # of turns) x 365 = Inventory days. In our example (1 / 5) x 365 = 73 days. So, from the time the company receives inventory, it takes 73 days to sell it.
Then we have to invoice the customer. Let’s say the customer is a large corporation with a 90 day payment policy. In that case it would take 90 days to get our money. But, most companies have more than one customer. Various customers pay at various times. To calculate the Accounts Receivable Turnover, take the net credit sales / average accounts receivable. For most companies that invoice, all their sales are invoiced. For our example: $1,200,000 in annual sales and $250,000 in Accounts Receivable. That is a A/R Turnover of 4.8. To convert to days, divide 365 by the A/R Turnover. 365 / 4.8 = 76 days. On average you receive payment 76 days from when you send the invoice.
Add up all the days from Cash to Inventory to Accounts Receivable back to Cash. This amount is the number of days in the Cash Cycle. In our example, it takes 73 days to sell the inventory and 76 days after the invoice is sent to receive payment. That is 149 days from the time you spend the money until you have money to spend. Basically you can turn you cash 2.45 times in a year (365 / 149 = 2.45). You might say, “this is great data, but how can I use this to help my business?”
By studying industry benchmarks (that we have access to for most industries in the U.S.) we can help you see what the average competitor does in these ratios. For example: you might learn that your average competitor has 60 days of inventory and 70 days of A/R. You can identify that you have 13 days of excess inventory. Taking 13 days back into your inventory level reflects that you need to hold 17.8% less inventory (or 17.8% * $100,000 = $17,800 (or $82,200 = new Inventory level). In addition, you have 6 days of excess A/R or 7.9% excess (6 / 76 days). That would reflect a decrease of $19,750 in A/R. This could be done by making phone calls to past due clients after 60 days or offering an incentive to pay within 30 days.
Making these small changes can add $37,550 to the cash balance. That represents an increase of 3.13% in cash to annual revenues. For some businesses, that is the difference between a success and failure.
This is just one example of Financial analysis that the SBDC can teach you to perform on your business. Understanding how money works in your business and your competitors can make your company more efficient. Our advisors can perform a custom financial analysis of your business and help you to understand where issues are hiding.
Learn how to use financial tools to make your business successful. Call (309) 677-2992 and set an appointment with one of our advisors.