Sponsored Article

Re-evaluating the cash conversion cycle in the COVID-19 era

This sponsored Viewpoint article has been provided by Taulia
The content below does not express the views or opinions of Spend Matters.
Visit https://taulia.com/ to learn more.

In these extraordinary times, maximizing working capital has never been more important. The COVID-19 pandemic has affected many sectors in different ways, be it a shift in demand from one type of product to another or a decline in activity/sales overall. Conversely, for some businesses, changes in customer behavior have resulted in a significant spike in demand.

In these market conditions, it’s more important than ever for companies to look critically at their cash conversion cycle (CCC) — the time taken to convert the firm’s investment in inventory into sales and receive payment for goods sold. The cash conversion cycle is a working-capital metric that is calculated as follows:

CCC = DIO + DSO - DPO

where DIO is “days inventory outstanding,” DSO is “days sales outstanding,” and DPO is “days payable outstanding.” To reduce the cash conversion cycle, a business can look at improving one of its three components: increase DPO, reduce DSO or reduce DIO. To maximize the improvement, they can address two or three of those areas at the same time. Generally speaking, a shorter cash conversion cycle is preferable because the longer a company’s cycle, the longer its working capital is tied up in its accounts receivable, accounts payable and inventory.

Impact of COVID-19 on the Cash Conversion Cycle

The disruption caused by COVID-19 has impacted companies’ cash conversion cycles in a number of ways.

For one thing, some firms have seen their DIO increase as orders slow down, meaning that it is taking them longer to convert inventory to cash — prompting some to turn to price reductions and promotions to keep stock moving. The retail industry in particular has struggled with fluctuations in demand and are having to manage stock levels accordingly. In addition, suppliers have long struggled with late payments from customers. The COVID-19 crisis has exacerbated this issue, with many small businesses reporting that customers are paying later.

A sudden increase in the cash conversion cycle can bring major challenges, particularly for smaller companies or for those with limited cash reserves. If the business is taking longer to generate cash, the company may struggle to meet its obligations and, in some cases, may not be able to continue operating. A longer-than-usual cash conversion cycle may also be a sign that inventory is being held for longer and is at risk of becoming obsolete.

Flexibility and Agility

While businesses may have been focused on the immediate impact of the crisis in the first instance, it’s important, now more than ever, to look ahead and consider how to reposition for success in the coming months.

In this rapidly changing world, flexibility is essential. Some companies have proved themselves highly agile when it comes to adapting their business models alongside changes in customer demand — for example, switching from physical branches to delivery services at short notice. As such, the most adaptable companies have been able to create an alternative income stream and keep the business running. Equally, as the crisis continues, companies will need to be able to adjust to changing conditions when lockdown conditions are lifted and, in some cases, reinstated if further outbreaks of the virus occur.

Sourcing is another area where there may be room to build in additional flexibility. With nationwide lockdowns and logistical delays occurring in different locations at different times, there is more reason than ever to diversify the supplier base. In some cases, it may be possible to put in place alternative sourcing arrangements to facilitate easy switching between suppliers in different locations if the need arises.

Optimizing the Cash Conversion Cycle

Where the cash conversion cycle is concerned, companies should also consider whether there is an opportunity to free up working capital by optimizing one or more components of the cycle.

First of all, companies should benchmark their working capital practices against others in the same sector to identify any areas in which they may be underperforming. Taking steps to maximize the effectiveness of the cash flow forecast within the context of the current volatile environment is also a great step. The more accurately that a company can predict its future cash flows, the better placed it will be to identify any upcoming cash gaps.

Armed with an accurate forecast, it becomes easier to identify opportunities to improve different components of the cash conversion cycle. This might mean reducing the number of days that cash is tied up in inventory by selling off excess stock, or reducing the purchase of raw materials in line with lower customer demand.

Where receivables are concerned, companies should take steps to reduce their DSO by increasing the effectiveness of their collections process, or by taking advantage of early payments offered by customers. This could be via solutions like supply chain finance or dynamic discounting.

It’s also important to keep in mind the impact of any working capital initiatives on the supply chain. In times of difficulty, while it may be tempting to extend the DPO by increasing the time taken to pay suppliers, as the UK Government’s Small Business Commissioner pointed out in a recent Working Capital Forum webinar, late payments can result in considerable difficulties for the suppliers. And if suppliers are facing an existential cash flow crisis, the effects of this can ripple further down the supply chain.

In conclusion, the current crisis has major implications on the cash conversion cycle. Taking the events of recent months into account, a sustainable approach to maintaining a healthy cash conversion cycle should involve and move toward optimizing working capital and harnessing flexibility within the business models where possible. Companies who do so will be better placed to thrive in the post-COVID-19 landscape, while supporting their suppliers at the same time.

Nodreen Kiwanuka is Taulia’s Digital Content Manager.

Share on Procurious

Voices (2)

  1. Dino Solari:

    NOTHING WILL BE LIKE BEFORE
    Impact of the virus corona (COVID-19) on the DSO
    A simple question. If your company does not invoice (or invoice much less) during the period affected by the corona virus, how will the calculation of the DSO behave in the following months? How will you understand if the change in the DSO is due to the non-billing (or decreased) or the payments not received in that period? And – above all – how many days will the variation be? ….. Are you sure of the measurement? In the calculation of the DSO, both with the mobile year method or with the backtrack method (also called countback or shrimp or backward) you take into account turnover and time …. All the calculation will then be distorted For this reason I use another method, WADL Weighted Average Days Late, which excludes turnover and is based on the weighted average of the overdue. It is necessary to enter into a new order of ideas and NOT consider turnover as a variable of credit exposure. You need to delete it from the calculation. Who wants to deepen let me know
    e-mail: dinosolari70@gmail.com
    “We can’t expect things to change if we keep doing the same things” (Albert Einstein)

  2. Dino Solari:

    se il fatturato nel post covid è crollato e i pagamenti hanno subito rallentamenti come si fa a calcolare il DSO sia con anno mobile sia con backtrack e confrontarlo con i periodi precedenti? questa misurazione è ancora valida? io dico di no.
    Esiste un metodo alternativo.

Discuss this:

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.