3 strategies to improve your cash conversion cycle

For many businesses, a high cash conversion cycle (CCC) is a silent killer. It means your own money is tied up funding operations for longer, severely restricting your ability to invest in growth, hire new talent, or even cover unexpected costs.

You've likely heard the generic advice to "buy software" or "be more efficient," but that's cold comfort when you're managing with a small team and a tight budget. 

This guide cuts through the noise. We'll walk you through a simple, step-by-step process to forecast your accounts payable, using tools you already have, to unlock your working capital and empower your business.

What is the Cash Conversion Cycle (CCC) and why it matters?

The Cash Conversion Cycle (CCC) is a key metric that measures the number of days it takes for a business to convert its investments in inventory and accounts receivable into cash. In simpler terms, it's the time between paying for goods and getting paid for them.

Think of it like this: Imagine you run a bakery. The cash conversion cycle is the time between when you pay for the ingredients (flour, sugar, eggs) and when a customer actually pays you for the finished cake. 

The shorter this time, the better for your business's cash flow. A shorter cash conversion cycle means your money is tied up for less time, allowing you to reinvest it, cover expenses, or seize new opportunities more quickly.

How to calculate your cash conversion cycle

To calculate your cash conversion cycle, you'll use a straightforward formula that combines three key metrics.

Let's break down each component:

• Days Inventory Outstanding (DIO): This measures how long, on average, your inventory sits in your warehouse or on your shelves before being sold. In simpler terms, it's how many days your stock remains unsold.
  
• Days Sales Outstanding (DSO): This metric tells you how long it takes, on average, for your customers to pay you after a sale has been made. It reflects the efficiency of your accounts receivable collection.
  
• Days Payables Outstanding (DPO): This represents the average number of days you take to pay your suppliers for goods or services. It indicates how effectively you manage your accounts payable.

By calculating your cash conversion cycle, you gain a clear picture of the efficiency with which your business manages its working capital. A lower cash conversion cycle generally indicates better cash flow management.

Why a low (or even negative) cash conversion cycle should be your goal

A low or negative cash conversion cycle isn't just a financial metric; it's a powerful indicator of your business's health and potential. Here's why aiming for a low (or even negative) cash conversion cycle is crucial for your small business:

Improved liquidity and financial flexibility

A shorter cash conversion cycle means your cash returns faster because you're collecting from customers sooner while paying suppliers later, keeping more working capital available for growth investments. This directly translates to improved liquidity, giving you more immediate access to funds. With better liquidity, you can:

• Reinvest in growth: Quickly seize opportunities like expanding your product line, upgrading equipment, or launching new marketing campaigns.
  
• Cover operating expenses: Ensure you always have enough cash to pay salaries, rent, and other essential costs without stress.
  
• Handle unexpected challenges: Build a stronger financial cushion to navigate unforeseen expenses or economic downturns.
  
• Reduce reliance on external financing: Less need for loans or lines of credit, saving you interest and fees.

The power of a negative cash conversion cycle

While a low cash conversion cycle is excellent, a negative cash conversion cycle is the ultimate goal for many businesses. This occurs when DPO is greater than your DIO plus DSO. In simpler terms, your customers pay you for goods or services before you even have to pay your suppliers for the raw materials or inventory.

Imagine selling a product and receiving payment before you've settled the invoice with your supplier. This means your suppliers are effectively financing your inventory, freeing up your capital. This is the ideal scenario because it means:

• Your customers are funding your operations: You're using other people's money (your customers' payments) to cover your costs before you have to use your own.
  
• Maximized working capital: Your cash isn't tied up in inventory or receivables, making it immediately available for strategic investments or unexpected needs.
  
• Increased profitability: By leveraging supplier terms, you can reduce your need for costly short-term financing.
  
  

How to audit your current cash conversion cycle in 3 steps

Before you can improve your cash conversion cycle, you need to understand where you stand. This 3-step audit will help you pinpoint exactly where your cash is getting stuck, allowing you to develop targeted strategies for improvement.

Step 1: Gather your numbers

To begin, gather the following financial statements: your income statement (also known as a profit and loss statement) and your balance sheet. You can find these in your records, or in accounting software like Xero or QuickBooks. 

You'll also need specific line items from these documents. Here's what you'll be looking for:

• Revenue: This includes all income generated from sales of goods or services, before any deductions. It's crucial for understanding the top-line performance of the business.
  
• Cost of goods sold (COGS): These are the direct costs involved in producing the goods or services your business sells. This typically includes the cost of raw materials, direct labor, and manufacturing overhead. A detailed COGS is essential for calculating gross profit.
  
• Inventory: This represents the value of goods held for sale in the ordinary course of business, or goods that are in the process of production for such sale, or materials and supplies to be consumed in the production process or in the rendering of services. Accurate inventory valuation impacts both the balance sheet and COGS.
  
• Accounts receivable: This refers to the money owed to your company by customers for products or services that have been delivered or used but not yet paid for. It's a short-term asset on your balance sheet and managing it well is key for cash flow.
  
• Accounts payable: This represents the money your company owes to suppliers for goods or services purchased on credit. It's a short-term liability on your balance sheet, and efficient management of accounts payable is vital for maintaining good supplier relationships and cash flow.
  
  

Step 2: Calculate your DIO, DSO, and DPO

Now that you've gathered your numbers, it's time to plug them into the formulas to calculate each component of your cash conversion cycle.

Calculating Days Inventory Outstanding (DIO)

DIO tells you how efficiently you're managing your inventory. A lower DIO is generally better, as it means your stock is selling quickly.

Example:

This means, on average, The Book Nook's inventory sits on its shelves for about 91 days before being sold.

Calculating Days Sales Outstanding (DSO)

DSO measures how long it takes, on average, for your customers to pay you. A lower DSO indicates that you're collecting payments quickly, which is great for cash flow.

Example:

This indicates that, on average, it takes The Book Nook about 18 days to collect payment from its customers after a sale.

Calculating Days Payables Outstanding (DPO)

DPO measures how long you take to pay your suppliers. A higher DPO can be beneficial as it means you're holding onto your cash for longer, but it's important not to damage supplier relationships.

Example:

This shows that, on average, The Book Nook takes about 46 days to pay its suppliers.

Step 3: Benchmark your score

Once you've calculated your cash conversion cycle, the next step is to understand what that number means in the context of your industry. A "good" cash conversion cycle isn't a universal figure; it varies significantly depending on the sector you operate in. 

For example, a grocery store might have a very low or even negative cash conversion cycle due to rapid inventory turnover and immediate cash sales, while a manufacturing company with long production cycles and extended payment terms might have a much higher cash conversion cycle.

To benchmark your cash conversion cycle effectively, research industry averages for businesses similar to yours. Industry associations, financial reports of public companies in your sector, and business intelligence platforms can provide valuable insights.

While comparing your cash conversion cycle to industry benchmarks is helpful, your primary goal should be to consistently reduce your own cash conversion cycle over time. This continuous improvement is a stronger indicator of better cash flow management than simply meeting an average.

To effectively monitor your progress and identify trends, it's highly recommended to track your cash conversion cycle on a quarterly basis. This regular review will allow you to see the impact of any changes you implement and make informed decisions to further optimize your cash conversion.

3 strategies to improve your cash conversion cycle

Now that you've calculated your current cash conversion cycle, it's time to act. Using specific strategies can greatly reduce the time your cash is tied up, freeing up money for growth and stability.

Here are three strong ways to improve your cash conversion cycle.

1. Reduce your Days Inventory Outstanding (DIO)

Optimizing your inventory management is one of the most direct ways to shorten your cash conversion cycle. By reducing the amount of time inventory sits unsold, you free up capital that can be reinvested or used to cover operating costs.

Let’s explore practical methods to achieve a lower DIO.

Identify and liquidate slow-moving stock

One of the quickest ways to free up cash tied in inventory is to identify and actively clear out items that aren't selling. These "dead stock" items not only take up valuable shelf space but also represent capital that could be better utilized elsewhere.

Action step: Regularly run an "aging inventory" report from your accounting or inventory management software. Anything that has been sitting in your inventory for over 90 days needs a dedicated plan. Consider strategies like creating bundle deals with faster-moving products, running flash sales, offering discounts, or even selling items on marketplaces like eBay. The goal is to convert these stagnant assets into cash as quickly as possible.

Implement a simple forecasting system

Accurate forecasting can significantly reduce your DIO by ensuring you order only what you realistically expect to sell. This prevents overstocking and minimizes the risk of accumulating slow-moving inventory.

Action step: While sophisticated systems exist, a small business can start with a simple spreadsheet. Track your past sales data for the last 3-6 months, looking for trends, seasonality, and popular items. Use this data to make more informed purchasing decisions rather than relying solely on "gut feeling" or historical bulk orders. This proactive approach helps align your inventory levels with actual customer demand.

Adopt a just-in-time (JIT) approach

Just-in-Time (JIT) inventory management focuses on receiving goods only as they are needed for production or sale, rather than holding large quantities in advance. For small and medium-sized businesses (SMBs), this means minimizing warehousing costs and reducing the capital tied up in stock.

Instead of buying in bulk to get a small discount and then having that inventory sit for months, a JIT approach means you order goods to arrive just as you need them to fulfill customer orders or production schedules. This requires strong relationships with reliable suppliers and efficient ordering processes. 

Action step: Modern inventory management software can significantly automate this process, allowing you to set reorder points and even automatically place orders when stock levels hit a predetermined minimum, ensuring you have enough product without excessive inventory.

2. Reduce your Days Sales Outstanding (DSO)

Efficiently collecting payments from your customers is critical for improving your cash flow and ultimately shortening your Cash Conversion Cycle (CCC). Your Days Sales Outstanding (DSO) directly reflects how quickly you turn your accounts receivable into usable cash. By implementing effective strategies to streamline your invoicing and collection processes, you can significantly reduce the time your money is tied up in outstanding invoices.

Improve your invoicing process today

The speed and clarity of your invoicing directly impact how quickly you get paid. Delays or confusion in your billing process can lead to extended payment times and negatively affect your DSO.

Action step: Send invoices immediately upon job completion, not at the end of the month.

This simple change ensures that the payment clock starts ticking sooner, reducing the lag time between service delivery and invoice issuance.

Action step: Ensure your payment terms (e.g., "Payment due in 14 days") are clear and prominent on every invoice.

Ambiguous payment terms can lead to delays. Clearly stated terms leave no room for misunderstanding and encourage prompt payment.

Make it easier for customers to pay

The fewer hurdles your customers face when paying, the faster you'll receive your money. Reducing "payment friction" is key to lowering your DSO.

Action step: Offer multiple payment options (e.g., Stripe, GoCardless, PayPal alongside traditional bank transfer). This reduces "payment friction."

Different customers prefer different payment methods. Providing a variety of options caters to their preferences and makes the payment process more convenient, increasing the likelihood of timely payment. Chaser also offers a dedicated payment portal that can further streamline this process, making it incredibly easy for your customers to pay you.

Automate polite reminders

Manually chasing overdue invoices can be time-consuming and awkward. Automating your reminders ensures consistency and frees up your valuable time.

You can set up automated email reminders within most accounting software (e.g., a gentle nudge 3 days before the due date, and another on the day it's late). This avoids awkward manual follow-ups and keeps the payment due date top-of-mind for your customers.

For a more streamlined and integrated approach, Chaser can connect to your accounting software and automatically send polite, yet persistent, reminders for unpaid invoices, significantly streamlining your collections process.

Consider invoice financing

Sometimes, despite best efforts, you need cash sooner than your customers can pay. Invoice financing offers a solution to unlock capital tied up in outstanding invoices.

Invoice factoring or discounting allows businesses to sell their unpaid invoices to a third-party financier at a discount. This provides immediate access to cash, helping businesses manage their working capital and significantly reduce their effective DSO, making it a common tool for businesses looking to improve liquidity.

3. Extend your Days Payables Outstanding (DPO)

Effectively managing your payments to suppliers can significantly impact your cash flow. By strategically extending your days payables outstanding, you can retain cash within your business for longer, providing valuable working capital without impacting supplier relationships. 

This section explores how to optimize your payment terms and processes to achieve a higher DPO.

Communication is everything

Extending your DPO isn't about paying your suppliers late or disrespecting agreed-upon terms. Instead, it's about proactively engaging with your suppliers to negotiate and agree upon more favorable payment terms upfront. This ensures transparency and maintains strong, mutually beneficial relationships.

Review all your supplier terms

Before approaching any supplier, you need a clear understanding of your current obligations and an overview of your supplier landscape. This will help you prioritize and strategize your negotiations.

Action step: Create a spreadsheet that lists all your suppliers and their current payment terms (e.g., net 30, net 15). Categorize them by criticality to your business operations. Identify which suppliers are essential and where you might have more leverage for negotiation.

How to ask your supplier for better terms

Approaching your suppliers for extended payment terms requires a diplomatic and strategic approach. Frame the conversation around mutual benefit and the longevity of your partnership.

Action step: Use a simple, professional script to initiate the conversation:

When having this conversation, focus on the long-term partnership and how improved cash flow for your business can ultimately benefit them through continued or increased business. 

Avoid making it solely about your company's immediate needs; instead, emphasize the stability and growth that a stronger financial position allows, which in turn solidifies your relationship as a valuable customer.

How to implement the strategy for your business

Translating the strategies listed above into tangible results requires a structured approach. This section will guide you through building a comprehensive action plan to optimize your cash conversion cycle, ensuring sustainable cash flow improvement.

Month 1: Start with the easiest things on the list

Focus on implementing no-cost strategies across DIO, DSO, and DPO. The goal for the first month is to achieve immediate impact with zero budget.

• Days Inventory Outstanding: Prioritize identifying and liquidating slow-moving stock. Conduct an immediate inventory audit to pinpoint stagnant items and launch clearance sales or bundle deals to convert them into cash.
  
  
• Days Sales Outstanding: Improve your invoicing process. Ensure invoices are sent immediately upon job completion and that payment terms are clear and prominent. Start manually sending polite reminders for payments due or slightly overdue.
  
  
• Days Payables Outstanding: Review all your current supplier terms. Identify which suppliers might be open to negotiating slightly extended payment terms without impacting your relationship. Start with less critical suppliers where you might have more leverage.
  
  

Months 2-3: Implement low-cost tools

Based on the biggest bottleneck identified in Month 1, invest in one area that can provide significant improvements with a modest investment.

• If DIO is your bottleneck: Consider a simple inventory management tool (many accounting software platforms offer integrated basic inventory features) to help track stock levels more accurately and set up basic reorder points. This will improve your ability to forecast and reduce overstocking.
  
  
• If DSO is your bottleneck: Invest in a better payment gateway or integrate additional payment options to make it easier for customers to pay. This might include services like Stripe, GoCardless, or PayPal if you're not already offering them. Look for tools that offer automated, polite payment reminders.
  
  
• If DPO is your bottleneck: Focus on streamlining your internal purchasing process to better manage payment terms. This might involve using a simple purchase order system within your accounting software to ensure you're aware of payment deadlines and can plan cash outflows more effectively.
  
  

Months 4-6: Measure ROI and consider automation

Now that you've implemented initial changes, it's time to measure their impact and consider more comprehensive solutions.

• Track your cash conversion cycle: Re-calculate your DIO, DSO, and DPO, and subsequently your overall cash conversion cycle(CCC), on a monthly or quarterly basis. Compare these new figures to your baseline audit from Step 3. Have your changes made a difference? Look for trends and specific areas of improvement.
  
  
• Analyze ROI: Evaluate the return on investment for any low-cost tools or strategies implemented in Months 2-3. Are the benefits (e.g., faster cash collection, reduced inventory holding costs) outweighing the costs?
  
  
• Consider automation: If your initial efforts have yielded positive results and you have clear data to justify further investment, consider more comprehensive accounting or accounts receivable (AR) automation software. Solutions like Chaser can significantly streamline collections, while advanced inventory management systems can integrate with sales forecasting for true just-in-time capabilities. This deeper level of automation can free up valuable time, further optimize your cash conversion cycle, and provide more sophisticated insights into your working capital.
  
  

Final thoughts

Improving your cash conversion cycle isn't a one-off task, but an ongoing business process. This is due to the constant evolution of market conditions, customer behavior, and internal efficiencies. Regular monitoring and adjustments are essential for maintaining optimal cash flow and financial health.

By systematically reducing inventory days, speeding up collections, and smartly managing payables, your business can build a powerful cash buffer, enabling greater financial flexibility and growth.

Now it's your turn. Apply the strategies outlined in this guide to audit and optimize your cash conversion cycle. Start with the easiest changes, measure your progress, and watch your business's financial health transform.

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