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Cash-to-Cash Cycle - Jacob J. Bierley, Jr., MBA Introduction
Lean views a business as a stream of value-adding activities that culminate in satisfying a customers' real needs. Key agents propel this stream. First and foremost of these are people. Their decisions and actions are the fundamental drivers of the value stream. Another is operating equipment. Some equipment transforms materials into the finished offering the business delivers to its customers. Other equipment transfers the offerings to the customer. A third factor that propels the value stream is cash. Yes, cash is a factor that fuels value stream activity. It is used to acquire and support activity by the other factors of production and, in that sense, shares in enabling their productivity. Like any of these factors, its availability for service constrains its utility—i.e., when it is not available, it cannot be adding value and therefore is simply waste. Use the concept of machine uptime as an analog for cash availability. If a machine is up, it can be put to productive use. If it is down for maintenance or repair—it is non-productive and thereby waste. When cash sits locked up and out of reach such that it cannot be invested in activities that propel the value stream, it too is non-productive and therefore waste. How do you measure whether you are operating "lean" with regard to cash? And, how does implementing lean improvements free cash to be value adding?
The Cash-to-Cash Cycle One way to detect how lean you are operating with regard to operating capital—the funds available for use in financing the day-to-day activities of a business—is to measure the length of the cash-to-cash cycle. The cash-to-cash cycle1 calculates the time operating capital (cash) is out of reach for use by your business. The speedier your cash-to-cash cycle, the fewer days your cash is unavailable for use in propelling your value stream. You can use this metric to gauge whether you are operating "lean" with regard to cash. Also, good performance on the cash-to-cash measurement has been associated with improved earnings per share (Ward, 20042).
When is Cash Out of Reach? Your business's cash is out of reach when it is uncollected from customers and when it is soaked up by inventory that sits on the shop floor, in office storage areas, or on computer disks. Uncollected payments are termed "receivables" and are reported on your business's balance sheet. How quickly a receivable is registered and how long it sits uncollected is determined by your business's order-to-cash-receipt value stream. Inventory is cash converted into materials and intermediate outputs that are not ready to benefit a customer. Think of inventory as a cash absorbing sponge. As long as inventory sits, it holds your cash captive. How long it sits is a function of how well your supply chain and production value streams are synchronized with customer demand. When these systems flow, are pulled by the customer, and free of all waste—inventory is zero.
Cash to Cash and the Extended Value Stream A neat feature of the cash-to-cash cycle is its ability to represent how efficiently the extended value stream is operating (Exhibit 1, below). As you know, for an enterprise to be truly lean, it must apply lean thinking to improving the operations of both its suppliers and its customers as well as itself.3 For the flow of cash to be optimized,4 you need alignment and synergy across the extended value stream.
How to Compute the Cash-to-Cash Cycle The cash-to-cash cycle is computed using the number of days that cash is invested in inventory plus the days that your uncollected earnings sit as receivables less the days cash remains available to your business because your business has yet to pay its bills (e.g., for goods or services from its suppliers). This last element may seem odd since one typically thinks of debts as money spent and gone. But, in business, just as in our personal lives, the longer a debt goes unpaid, the longer that cash remains with the business (or us) and therefore available for use. This reverse benefit from not paying debts does create an opportunity to improve your cash-to-cash cycle in ways that are inconsistent with the lean model—and we will discuss this below. For now, it should seem clear that the faster your business turns over its inventory, the faster it bills and collects what is owed to it, and the slower it pays its debts—the better its operating cash position. Exhibit 2 presents how to compute the cash-to-cash cycle time.
Think about this formula for a moment and it should make sense. The days a business's cash sits locked-up as inventory, it is unavailable. Since these days extend the cash-to-cash period, add them. The more days the cash a business earns through sales is uncollected, the longer the cash remains unapplied to adding value, so we add these days as well. On the other hand, the longer the business holds on to its cash by not paying a debt it owes, the more cash it has to propel its value stream. We therefore deduct these days from the cycle to reflect that cash is available. Again, this last element has a funny ring to it because it suggests that it is to a business's benefit to drag its feet in paying what it owes or pressure vendors to accept longer and longer repayment period. And, as you can see from the formula, it will make the business look better on this metric.5 But, put that concern aside. For now, see how this metric works. Exhibit 3 presents how to calculate each component that contributes to the cash-to-cash cycle time.
Example Exhibit 4 presents excerpts from the XYZ Business's Balance Sheet and Profit/Loss statement for January 2006. All dollars are reported in units of a million.
Using the information in Exhibit 4, we can compute XYZ'z cash-to-cash cycle time for January (Exhibit 5).
Based on this information, XYZ had its operating capital locked-up for 24.4 days before it became available. The performance is less speedy when the effects of holding payments to vendors is extracted (33.2 days).
Desired Results of Cash-to-Cash Cycle In a truly Lean system, there is no waste in any value stream. Goods are not manufactured or shipped to the customer unless “pulled” and they are produced by production systems that flow continuously without reliance on inventory. Raw materials are not acquired and processed unless a customer demands a finished output. Customers are billed and pay immediately upon receipt of a purchased product or service. In its ideal state, it is a just-in-time system from the origins of its supply chain through to the receipt and payment by its customer. In this scenario, the lean producer also pays its suppliers upon receipt as its customers pay upon delivery. There are zero receivables, inventory, and payables and thus a zero day cash-to-cash cycle time. Although a zero-day cash-to-cash cycle is truly Lean, your business approaches its best achievable state progressively by shortening the cycle times it initially displays.
Interpreting Cash-to-Cash Cycle While a shorter cash-to-cash cycle is generally considered a positive indicator of operating leaner, you need to look deeper to be sure. You can achieve shorter or even negative cycle times by means that are inconsistent with lean. As stated previously, you can shorten your cycle times by pressuring your vendors to accept delayed payments for goods they deliver.7 With regard to longer cycles, some industries have inherently longer lead times for accomplishing their value streams than other industries. If you build large complex outputs like warships or office towers for example, your business's cash will be tied up longer than say for a business that is a computer systems integrator, like a Dell or Gateway, where they assemble their products in minutes. To properly evaluate your cash-to-cash cycle performance, you need to analyze your cycle time in conjunction with other information. First, always assess it over time. The trend of your cycle time is more critical than its value at a single point. Second, if you want to understand a point-in-time value, look to the typical cash-to-cash cycle for other businesses in your industry.6 You always want to have faster conversion cycles than your competitors. Third, before celebrating any apparent achievement in cash-to-cash speed, make certain that you read and apply the cautions described below. Each explains a way you can achieve fast cash turnaround that we would not perceive as worthy or smart from a lean perspective.
Cautions
How to Improve Cash-to-Cash Cycle To improve your cash-to-cash cycle, begin internally. Start by reducing your inventory and increasing inventory turnover. This will speed the cash-to-cash cycle. In parallel, Kaizen your order-to-cash-receipt work processes. Speed the invoicing process, reduce billing errors, speed response to overdue bills, and reduce the incidence of bad debts. As your cycle time and error rates come down, cash becomes available to enable timely payment of your suppliers and redeployment in your business. Next, develop a supply chain that reliably provides you exactly what you need, just when you need it, with the least waste incurred on the part of your suppliers and your business. This will minimize both inventory and the cash you need to spend for the inputs you require. Remember, as you pursue perfection, be certain to implement improvements that benefit all members of the extended value stream. Lean requires inclusive thinking so that optimization of one component does not create waste or diminish value in another component.
About the Author Jacob J. Bierley, Jr. received both his MBA in Finance and BS in Accounting from Indiana University's Kelley School of Business. He has 14 years in auditing and accounting management. Mr. Bierley is currently the Controller for Bunge Oils for Bunge North America where he coordinates all aspects of accounting controls, practices, processes, and policies in support of Bunge Oils. Bunge North America is a primary supplier of high-quality agricultural commodities and value-added, specialized food and feed ingredients and food products to the global marketplace.
Footnotes 1Also referred to as the "cash conversion cycle." 2Ward, Peter (2004) Cash-to-cash is what counts. Journal of Commerce, February 16, 2004. Available online at: www.hitachiconsulting.com/downloadPdf.cfm?ID=57. 3Womack, James P. and Jones, Daniel T. (2003) Lean Thinking. (Revised and Updated) New York, NY: Free Press, page 327. 4Optimizing the cash-to-cash cycle time from a lean perspective has a different meaning than from a traditional producer-focused perspective. In a lean perspective, optimum sustained competitive advantage comes from working interdependently with your suppliers and customers. In a producer-focused competitive strategy, advantage is believed to result from controlling the behavior of suppliers and customers to advantage your business. For example, given the opportunity, you would force vendors to accept longer payment periods so they, in effect, extend your business interest free loans. Also, you would use market controlling methods to restrict customer choices—e.g., advocating for tariffs on the offerings from competitors. 5From a lean perspective, benchmarking can be a distraction as your intent is perfection, not just performance better than your competitors. Nonetheless, if you need to evaluate a point-in-time value, comparison to a benchmark is needed. If possible, consider industry average, best in class, and world-class benchmarks. Ward (2004) offers some benchmarks based on his research. Ward reports the following cash-to-cash cycle times: For "Tier 1" automotive companies - 40 days; heavy industry companies - 200 days; consumer goods sector between 50 and 150 days; and supermarket chains - 10 to 35 days. 6There are alternatives to using COGS is this computation. For example, one might use Annualized Materials Cost as a substitute. Neither is ideal. Both metrics have a degree of distortion in them. COGS inflates payables to suppliers by including the cost of goods and services supplied internally. On the other hand, annualized materials cost deflates payables to suppliers by not including the cost of contracted services (e.g., personnel, utilities, other services). In some industries, these non-material supplier costs are a great deal of money. So, each has a degree of distortion and the distortion varies by industry. The ideal would be segmenting payables by supplier type so that employee labor, for example, might be extracted and a "pure" and complete externally sourced cost computed. I like COGS because it allows you to compare cash cycle metrics between different companies and industries. Also, COGS is a commonly reported item in financial reports, whereas material cost may not always be reported as it is a subset of COGS. If you have a choice within your company as to which metric to use, I suggest selecting the metric that reliably provides you the most accurate information about all your supplier payables. 7Bierley, Jacob J. (2006) Inventory turnover. Hope, ME: Vital Enterprises. Available online at: http://www.vitalentusa.com/learn/turnover.php. Published February 2008, Revised December 2008
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