Session # 205 5/18/17 from 2:00-3:15 Cash Conversion 250 Commercial Street, STE 3012 Manchester, NH 03101 Cycle (603)573‐9206 Breathing Life into a Stale Dying Process Background FASB describes liquidity as reflecting “an asset’s or liability’s nearness to cash” (Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises; PP 24, Footnote13). In accounting and auditing textbooks, the current and quick ratios continue to be the focus of liquidity analysis. Noticeably absent from most accounting and auditing textbooks is an approach to liquidity analysis that incorporates the element of time—the cash conversion cycle (CCC), was introduced in 1980 by Verlyn Richards and Eugene Laughlin in their article “A Cash Conversion Cycle Approach to Liquidity Analysis,” Financial Management, Vol. 9, No.1 (Spring 1980). Consideration of the CCC along with the traditional measures of liquidity should lead to a more thorough analysis of a company’s liquidity position. Static measures of liquidity, such as the current ratio, do not account for the amount of time involved in converting current assets to cash or the amount of time involved in paying current liabilities and…can be easily manipulated. Methodology Let’s discuss the elephant in the room… Static Measures of Liquidity An illustration of Static Measures Company A has $1,000,000 in current assets and $750,000 in current liabilities. The current ratio reveals that the Company A can cover its current liabilities with its current assets 1.33 times [$1,000,000 ÷ $750,000]. If Company A wished to maintain a higher current ratio or if a creditor’s loan covenant requires a higher current ratio, Company A could pay $500,000 of its current liabilities. As a result, Company A would then report $500,000 of current assets and $250,000 of current liabilities. The current ratio calculates to a 2.0 [$500,000 ÷ $250,000], but this action could have actually harmed the company’s liquidity position, leaving it with $500,000 less cash to meet unexpected needs. Furthermore, if those current liabilities were not due for another month, then Company’ As desire to report a better current ratio could have cost the business a month of interest-free financing of liabilities and a month’s return on the cash that could have been invested elsewhere. A high current ratio will also result from buildups of accounts receivable, a situation that is not necessarily desirable. The effects of lengthening the collection period of receivables, an act that harms company liquidity, would not be readily apparent in either the current ratio or the more conservative quick ratio. A disadvantage of static measures of liquidity - despite how simple they are to compute; can be quite difficult to interpret. Higher is generally considered better, but too high may indicate inefficient use of assets. Lower is generally regarded as unfavorable but may actually be the result of an efficient use of working capital. A current ratio of approximately 1.0, which would indicate that the company is barely able to cover current liabilities, does not necessarily indicate a weak liquidity position if the company manages its working capital with such precision that the inflows of cash can be matched with the required outflows of cash. Cash Conversion Cycle (CCC) CCC The CCC calculates the time required to convert cash outflows into cash inflows. It indicates how efficiently a company is using its current assets and liabilities. Each stage of the CCC is illustrated below. CCC Formula = (+DIO +DSO –DPO) + Days Inventory (DIO) = AVG Inventory * 365 COGS + Days Sales (DSO) = AVG A/R * 365 REVENUE - Days Payable (DPO) = AVG A/P * 365 COGS Business Timeline – Standard Is this realistic? CCC - Standard Process: DIO = 7,000/15,000*365=170.3 AVG DSO = 5,000/32,000*365=57.3 DPO= 3,000/15,000*365= 73 AVG AVG CCC = +171+58-73= 154.6 Forecast: -55 Business results CCC Key Business Drivers Build Architecture- Define ‘thy inner self’ Many companies’ report business performance measurements (BPMs) through arcane processes and disconnected spreadsheets. Putting them together requires a great deal of effort, yet lack accountability and process ownership is unclear. The constant across companies is that treasury professionals generally try to avoid being saddled with this responsibility. Usually, treasury professionals see little upside for coordinating a company's cash flow forecasting and measuring efforts, yet may face the wrath of C-level executives if forecasts and measurements fail to align with strategic goals. For a treasury team, inaccuracies in cash flow forecasts and measurements are more costly today than ever before. Because of turbulence in the external economic environment, as well as investors’ and analysts’ increased interest in corporate cash flows, senior management is paying more attention than ever before to the cash conversion cycle process. The treasury department is also under increasing pressure to intervene and make significant process improvements. Objectives - CASH IS KING Reduce Inventories Excess inventory is one of the most overlooked sources of cash. By streamlining processes within the company—as well as processes involving suppliers and customers—companies can minimize inventory throughout the value chain. • Enhanced forecast accuracy and demand planning: Improved forecast accuracy and regular updates of customer demand lead to a much more reliable planning process and help companies not only to reduce their inventory but also to improve the ability to deliver. • Advanced delivery and logistics concepts: In order to keep inventories at lower levels, top-performing companies establish advanced and demand-driven logistics concepts with their suppliers, such as vendor-managed inventory, just in time (JIT) or just in sequence (JIS) and collaborate with their suppliers. • Optimized production processes: An important lever to reduce work-in-progress inventory is the redesign of production processes. The main objectives here are to reduce non-value-adding time (“white- space reduction”) and excessive inventory between production steps. Promising measures are removing bottlenecks and migrating from push concepts to demand-driven pull systems. • Service level adjustments: An increased service level for products which are critical to the customer (and thus allow higher prices) and a decreased service level for products which are uncritical to the customer should lead to optimized stocks. A sophisticated approach to calculating security stocks based on target availability and deviations in production & demand will also reduce out-of stock situations for critical parts. • Variance management: Reducing product complexity and carefully tracking demand of product variants in order to identify low-turning products is one way to reorganize and tighten the assortment and concentrate on the most important products. Reduce Receivables Many companies are early payers and late collectors—a formula for squandering working capital. Other companies—particularly project-based businesses and manufacturers of large, costly products with lengthy production cycles—have cash flow problems caused by a mismatch in timing between costs incurred and customer payments. Efficient management of receivables and prepayments received is key. Optimization can yield significant potential. • Invoicing cycle: The main target is to get invoices to the customers as quickly as possible. Processes and systems should be aligned to allow invoicing promptly after dispatch or service provision. Companies can reduce invoicing lead times by multiplying their invoicing runs. • Early reminders/dunning cycles: Best-in-class companies reduce grace periods to a minimum or remind their customers of upcoming payments even before the due date. Establishing direct debiting with main customers is the most effective means to avoid overdue payments. • Payment terms: Renegotiated payment terms will lead to reduced DSO. The first step is often a harmonization and reduction of available conditions to decrease discretionary application. When preparing negotiations, companies should analyze their customers’ bargaining power and specific preferences in order to identify improvement potential in the terms and conditions for payments. • Payment schedule: Companies operating in project business should introduce more advantageous payment schemes that cover costs incurred. Percentage of completion (POC) accounting helps to define relevant payments along milestones. Companies with small series productions, the introduction of prepayments and advances can significantly improve liquidity. Rethink Payment Terms with Suppliers If fast-paying companies are at one end of the spectrum, then companies that “lean on the trade” and use unpaid payables as a source of financing are at the other. Between these two extremes there is a more effective, integrated approach to payment renegotiation that takes into account all aspects of the customer–supplier relationship, from price and payment terms to delivery time frames, product acceptance conditions and international trade definitions. • Payment cycle: Payment runs for payables can be reviewed and limited to a required frequency. Country-and industry-specific business conventions apply. Moderate adjustments of payment runs may require some changes in the accounting systems, but tend to be a “quick hit.” • Avoidance of early payments: Payments should be accomplished with the next payment run after the due