Your small business thrives on sales and cash flow. You use cash to buy inventory, sell that inventory, and then receive payment from the customer that includes a profit — before the cycle starts all over again. But how much time occurs during this cycle? Do you have enough cash to cover expenses at any given time? There’s a way to track this cycle.
The cash-to-cash cycle is the time period between when a business pays a vendor for goods and when it receives payment for selling those goods. It’s a financial method you can use to measure your business’s turnover and efficiency. This information can also help you with creating a workable budget. By tracking the number of days it takes for your business to complete the lifespan of goods, you can understand where and when lags and bottlenecks happen.
Cash-to-Cash Cycle Formula
Even though the cash-to-cash cycle is an important measurement on its own, it’s actually the combination of three separate financial measurements.
- The time it takes to pay for inventory is calculated as the days payables outstanding.
- The time it takes to convert inventory into a sale is calculated as days inventory outstanding.
- The time it takes to collect cash from a sale is calculated as the days sales outstanding.
By adding these three calculations together, you can track your business’s entire cash-to-cash process. The total number of days provides you with your business cash cycle.
Days Payables Outstanding (DPO)
You measure the days payables outstanding from the moment you receive inventory and have a legal obligation to pay for it. You calculate DPO by multiplying your average payables balance by the number of days in the period and dividing the result by the cost of your inventory. You get the average balance of accounts payable by taking the average between the beginning balance and ending balance for any period.
This calculation sheds light on your business’s ability to process payments. It isn’t indicative of cash flow problems, but if you have difficulty paying your bills on time, you have a higher DPO calculation. You should strive to have a high DPO while paying your bills by their due dates.
For example, if all vendors have payment terms of net 30, it’s reasonable for a company to strive for a DPO of 25. This avoids late fees and maintains relationships with vendors. Paying your bills on time also maximizes your cash flow efficiency. A DPO calculation of 25 means that your company takes an average of 25 days to pay its bills.
Days Inventory Outstanding (DIO)
Calculate days inventory outstanding by dividing the average balance of your inventory by the cost of sales and multiplying the result by the number of days in the period. The average balance of inventory is the average between the beginning and ending inventory reported.
Unlike the DPO, you should seek to minimize your DIO. The DIO represents the number of days on average an inventory item sits in your stockroom waiting for a customer to buy it. During this period, the asset ties up your cash, and it isn’t producing any income. So, you should take all measures to decrease your DIO. such as marketing to raise awareness about your inventory or adjusting your prices.
Days Sales Outstanding (DSO)
The days sales outstanding is a measurement of the time it takes to receive payment once the inventory has been sold. This period starts once the inventory sells and ends when the cash payment arrives at your company.
Similar to the DIO, you can strive to minimize the number of days for this metric, because every day you hold onto an account receivable, you have less cash at your disposal to grow your business. And, a higher DSO is an indicator that customers are slower to pay and may result in uncollectible accounts. Calculate DSO by dividing the average accounts receivable balance by the total credit sales for a period and multiplying the result by the number of days in the period.
Usefulness of Cash-to-Cash Cycle Calculation
The cash-to-cash cycle calculation can be useful in many ways. First, you can translate it into any period. For example, to find the cash-to-cash calculation for a specific quarter, you can use 90 or 91 days in each equation. To find the calculation for an entire year, use 365 days. In each case, you can target a specific time period which is important for seasonal businesses with fluctuating cash flows.
The cash-to-cash cycle translates well across industries. By analyzing the cash-to-cash cycle of competitors, you can address your business’s weaknesses. For instance, if the industry average DSO is five days shorter than your calculation, you should consider whether you’re issuing credit terms in line with the rest of the industry, extending too much credit, or not reviewing the creditworthiness of your customers enough.
Also, you can compare the cycle across time frames to determine the progress of operational changes and whether your company is improving. Ultimately, the cash-to-cash cycle provides insight to your business’ entire operational process, from the purchase of inventory to the customer payment for the product.
As a small business owner, you have the responsibility of understanding these cycles and always seeing the complete picture of your company’s financial health. Improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.