Cash Cycle Explained

Without profit, your business will starve, but it may take a while. (It took Amazon.com ten years to show its first profit.) Cash, on the other hand, is like oxygen. You just can’t get very far, for very long, without it.

So, cash and cash flow are important. Got it. So what holds people back from learning how to manage their cash better?

In part, the hesitation may stem from an aversion to all the accounting jargon that is associated with the topic. The purpose, therefore, of this workshop is to bring some clarity to the subject of cash flow.

The Cash Cycle Explained

The concept of the cash cycle is the foundation upon which cash management strategies are built. The idea is straightforward: the cash cycle is the delay between the time you make an expenditure to buy or make your product and the time at which you collect payment for your product from a customer:

The Cash Conversion Cycle
The Components of the Cash Cycle

The longer your cash cycle, the more cash will be tied up as an investment in your business. The greater the rate of investment, the more capital – debt or equity – you’ll need to maintain and grow your sales.

The Determinants of the Cash Cycle

Three factors determine the duration of your company’s cash cycle:

  • The average number of days your product stays in inventory – If your factory is located halfway around the globe; your minimum order quantities are high relative to your sales rate; and you want to minimize the number of stockouts and lost sales, your “days in inventory” will be fairly high. The longer the average product stays on the warehouse shelf, the longer your cash cycle. On the flip side, an ecommerce retailer who relies on drop shipping won’t hold any inventory. As a consequence, its cash cycle can be very short.
  • The time it takes to collect payment on an invoice – If you sell to large, wholesale customers, it make take 30, 60, or even 90 days or more, on average, to collect an invoice. Big companies will usually pay you, but it may take a while. On the other hand, if you sell direct-to-consumers online, you may collect credit card receivables within a few days. The longer it takes to collect receivables, the longer your cash cycle.
  • The time it takes you to pay your bills – It turns out that suppliers and landlords like to get paid on-time. That means us little guys usually have to pay our bills within 30 days. Big companies play by a different set of rules. The longer you can stretch your payables, the shorter your cash cycle.

Note that some businesses have a negative cash cycle. That is, they can collect sales receipts faster, on average, than they make payments to their suppliers. For example, in 1996 Amazon.com operated to a significant degree as a drop shipper of books. It collected sales proceeds immediately from its online customers, but it took about 90 days, on average, to pay for the books sold.

Amazon has relied on accounts payable and a negative cash cycle since the company began selling books online…much of its operating cash was raised by growing its accounts payable. In many years, this was enough to cover the company’s negative net income and intensive capital expenditures as it built out its sophisticated distribution system.

Retail Revolution

The points being:

  • Our strategic choices, competitive circumstances, and management practices determine the cash cycle of our businesses.
  • The duration of the cash cycle determines how much cash we’ll need to support the growth of our businesses.

How Much? When? For How Long?

Understanding what the cash cycle means and how it’s determined is a building block toward a deeper understanding of the cash flows and cash balances of your business over time. However, the basic cash cycle is a static model – like a snapshot. We need a moving picture to help us develop a dynamic understanding. We’ll make a movie in other lessons in this course using a visual modeling tool called Sysdea.