Optimizing Cash Flow: The Cash Flow Cycle Explained

Intro: Cash Flow Cycle Explained | 1. Onboarding | 2. Invoicing | 3. Vendors | 4. Metrics | 5. Accounts Receivable Problems

I have a confession to make: I’ve owned a lot of businesses and I don’t always know where my cash is.

Here’s the key:

1. You put money into the business to make a purchase.
2. You pay your vendors. Money is now out of your company.
3. You might assemble a product. You might make something. You might bake something.
4. You’re going to hold some inventory. While it’s in inventory, it’s not cash.
5. Then you sell it. Still not cash until you collect it.
6. Finally, you collect it and now you’ve got cash to make a purchase.

So out of the entire cycle, where’s the cash? A little tiny piece of the pie. About 10 minutes out of the hour.

• A/P is Accounts Payable. It’s a time between a purchase and a payment.
• A/R is Accounts Receivable. It’s the time between a sale and a collection. Everything else is inventory.

If you understand the concept that your money is in various places at various times in the cycle of your business, you can then calculate the number of days that it takes to go around the cycle.

Three simple formulas

Days Sales Outstanding + DSO = A/R ÷ SALES × 365

Days Sales Outstanding (DSO) is equal to your accounts receivable (A/R) at any point in time, how much money do your clients owe you, divided by your annual sales; how much have you sold in the year, time 365 days.

Days Payables Outstanding − DPO = A/P ÷ PURCHASES × 365

Days Payables Outstanding is equal to accounts payable (A/P), divided by total purchases of the year. How much did you spend, all year long, on anything, multiplied by 365.

Days Sales in Inventory + DSI = INVENTORY ÷ COGS × 365

That’s the big black hole where you’re holding on to things that you’ve made. That’s the value of your inventory from the balance sheet, divided by the cost of goods sold for the whole year, multiplied by 365. Notice I said a whole year on each of these things. It’s important that these two terms match in the period that you’re measuring. So, if you were to do COGS for one month, multiply that times 30, instead of 365. For this example, we’ll keep it at a year.

Cost of goods sold for a whole year, times 365. 

Purchases for a whole year, times 365. 

Sales for a whole year, times 365.

If you can do those three pieces of math quickly, using your balance sheet and your income statement, then you can start to see the total number of days in your cycle. Add the days sales are outstanding, subtract the number of days you get back by letting your vendors finance your customers, then add the number of days in your inventory. In most businesses, AR runs about 45 days. In most businesses, accounts payable is less than accounts receivable, maybe only 30 days, so you’re 45 – 30, you’ve already got 15 days that you need to finance and if you hold inventory for another three months, guess what? You’re at 105 days’ worth of cash tied up in your business. You can play that game with all kinds of different numbers and you can see how a business could really go broke just trying to keep the doors open, because you’re storing cash inside the cycle. That’s important.

DSO – DPO + DSI

Keep that total as low as you can and read my blog about Dell Computers. I’ll show you how Dell Computers has a negative cash flow cycle. They use your cash to build machines that they sell you and have more cash than they need to keep their business running.  It’s a great trick.

Shoot for that target. Go out and act.  We’ll see you next time.

To your success,

David Worrell

Intro: Cash Flow Cycle Explained | 1. Onboarding | 2. Invoicing | 3. Vendors | 4. Metrics | 5. Accounts Receivable Problems