We may be close to a turning point where interest rates will rise and capital availability tightens, due to the recovering economy and the impact of the upcoming mid-term elections.
For the private, middle-market companies that Newport Board Group serves, the main traditional sources of financing for growth have been capital internally generated from profits; capital contributed by the owners and their family and friends; and bank lines of credit. However, there are other ways to finance the growth of your business interest-free and without borrowing money.
Financing With Alternative Methods
The most successful businesses in the middle market economy utilize a funding source that has been called “Other Peoples’ Money.” This refers to the timing of payments from customers relative to the timing of payments to suppliers. Smart companies set policies and processes so that these timings maximize cash flow and avoid incurring debt to finance operations. Two concepts that these smart companies are very familiar with and exploit to the hilt are “Cash Conversion Cycle” and “Corporate Trade Credits.”
The Cash Conversion Cycle (CCC) measures how long a company will be deprived of cash that it uses for purposes such as expanding its inventory in order to expand its sales. CCC is essentially a measure of liquidity risk, the cash shortfall that is created when a growing company uses cash to expand its operations.
When companies take an extended period of time to collect outstanding receivables or over produce due to poor sales forecasting, their CCC lengthens. For smaller businesses, a long CCC can be damaging, even fatal, as the business has to pay bills due to vendors for inventory or other goods and services faster than it is receiving cash from its customers.
The CCC calculates the time it takes to convert inventory into cash. It is composed of three categories: days sales outstanding (DSO), days payable outstanding (DPO) and days inventory outstanding (DIO). Days sales outstanding is the amount of time a company takes, on average, to collect amounts due from customers. Days payable outstanding is a firm's average period of time to pay bills. Days inventory outstanding is the amount of time, on average, a firm takes to convert inventory to sales.
To calculate a CCC, add days inventory outstanding (DIO) to days sales outstanding (DSO), then subtract days payable outstanding. A lower CCC means that the company’s operations are more cash-efficient. A similar calculation can be made for service companies as to the timing of when they pay employees and contractors and when they get paid for the services they provide.
In the second part of this series I will discuss CTC and focusing on individual customers’ and suppliers’ contribution to your company’s liquidity.
About the Author
As a partner with Ernst & Young, Mike Evans developed, led and drove significant growth in a number of practices. Mike’s experience also includes work with middle market entrepreneurs in which he advised many small-medium clients in Silicon Valley on tax strategy and planning. Contact or learn more about Mike here.
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