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The alphabet of Finance doesn't start with ABC but rather CCC

No concept is more important to grasp than the Cash Conversion Cycle, abbreviated CCC. Cash is the lifeblood of every business and flows through each of its veins. If one of the veins is clogged the risk of a full-blown heart attack is becoming increasingly likely.

When I talk about the veins of a business I naturally view it through the lens of a beancounter, and we like to call the veins receivables, payables, and inventory. The Cash Conversion Cycle keeps these three areas in balance and with it, the financial health of the business. I promise you that once you have truly absorbed the concept your business can be as successful as Amazon from a financial perspective. Trust me I am sober while writing these lines and I mean it with the Amazon comparison. For many years Amazon was not turning a single profit, however, the business kept on growing and expanding. It is not a secret anymore that Amazon was a champion when it came to inventory and cash-flow management. I remember that I once worked on a case study about Amazon during my business school years. The result of my case study work was that the well-managed Cash Conversion Cycle was standing out and it helped Amazon to grow and attract more and more investment. How was this possible: Fast inventory turnover, cash upfront (remember that Amazon collects payment before goods are shipped), and stretched supplier payment terms. This led to a continuous cash surplus. Quite smart in my opinion when your business is on the path of rapid growth. Let's review the components of the Cash Conversion Cycle before we dive a bit deeper into the actual calculation.

But I wouldn't be a jolly beancounter without a jolly good example, so imagine you want to set up a business in Bavaria as the Germans recently discovered their taste for "Real English Ale". You have secured a deal with a big restaurant chain that operates various beer gardens. You set up shop in the Black Forest where you brew your real ale.


Payables

To get things started you organize delivery of some ingredients to brew your real ale. You found a wholesale supplier of hops, barley, and yeast from Kent. The supplier delivered ingredients worth 10.000GBP to your brewery in the black forest. He gives you 30 days credit terms before you have to pay him in cash. Quite generous but you convinced him of our bulletproof deal. In general, Accounts payable or payables refers to what you owe for goods and services purchased on credit. This is important because companies normally try to pay as late as possible. The supplier does not charge for this kind offer, no interest, no fee absolutely nothing. The supplier basically trusts you that he/she will receive payment at the end of the credit term whether it 30, 60, or 90 days. Therefore companies normally try to push for the longest term possible.


Inventory

Inventory is everything that is used with the ordinary course of production of a product, such as raw materials, tools, oils, and other lubricants, etc.. Without inventory, there would be no final product. IMPORTANT: Machines are not part of inventory as they are a means of producing a product. Think about it in this way, inventory is consumed and integrated into the final product whereas other items such as machines do not form part of the product but are used to produce it. In the case of our example, barley, yeast, and hops are all incorporated in the beer whereas the various types of equipment such as kettles are means to produce the beer. Both things are accounted for differently by beancounters such as myself. But back to inventory, in our case you use the barely, hops, and yeast to brew the delicious ale. You agreed with your customer that you will deliver all the beer at once in order to make it nice and easy for both parties. You think it will take you 3 months to finish the brewing. This means it takes 90 days before you can sell your ale to the customer.


Receivables

Finally, after 60 days of working day and night in the brewery, you have sold your real ale for 15.000GBP to the German restaurant chain. Great! Well done. This makes for a roaring profit of 5.000GBP. But what about cash? So far the only cash you have seen was the one that left your pockets. Remember you had to pay the supplier from Kent 60 days ago. (90 days minus the 30 days payment terms from the supplier). Now let's turn to the receivables. If you sell goods or services to your customers on credit, your business will always have accounts receivable or receivables (both terms are used interchangeably). You agreed with the German restaurant chain to get paid 60 days after delivery. Oh Lord 60 days! This is quite a long time before you get even and have the cash in your pockets. So, 60 days ago you already paid 10.000GBP to the supplier, and now you have to wait a further 60 days before you get paid yourself. In effect you have to wait 4 months before you can 1.) get even on the costs for the ingredients and 2.) get a reward for your own hard labor. But who can wait 4 months?


Conclusion

Do you see the problem with the above example? You as the brewer only thought about the profit and not about the cash when you dealt with the various parties. In 4 months you can run out of money in order to pay your bills, mortgage, etc. because all your money went to the barley, hop and yeast supplier. You could have negotiated differently for example by demanding 60days from the supplier and upfront payment by the customer. This would have reduced the final waiting time to only 1 month/30 days. Sounds far better, in my opinion!

This is what essentially is called the cash conversion cycle:




You would not believe how many company leaders have not got this concept on the radar, they must have really good beancounters.

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