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In the logistics industry both the operating cycle and the financial cycle have many benefits and risks. Cash flow is a basic indicator of the health of the organization; therefore cash requirements must be constantly reviewed to adjust forecasts for unusual events such as seasonal fluctuations, slow-moving inventory, significant one-time payments, and missed targets. The cash conversion cycle must be calculated to assure that liquidity risk is diminished.
First, let's analyze the key components of the cash conversion cycle and then how partnering with a financial solution provider will minimize liquidity risk and drive growth with healthy cash management.
Any segment of the supply chain organization that needs to purchase goods as part of its operating cycle, needs to be concerned about liquidity risk. By examining the cash conversion cycle, management can measure how effectively a company can convert current cash to even greater cash. The cycle starts with acquiring inventory on credit which creates a liability, selling the goods on credit which creates trade accounts receivable, paying for the inventory, and then collecting on the sales. Unfortunately, in today's economic environment, vendors are demanding payment faster, inventory sits on the books longer, and customers are taking longer to send in payment.
The cycle is measured by three components measured in days, accounts receivable outstanding, accounts payable and inventory. By adding the number of days trade receivables are unpaid (DSO) plus the days inventory is on hand (DIO) and subtracting the number of days it takes to pay vendors (DPO), we come up with the cash conversion cycle. The basic takeaway is the lower the cycle, the lower the liquidity risk.
DSO measures the number of days needed to collect on credit sales. The computation is the accounts receivable balance divided by average revenue per day.
DIO takes into account how many days it takes to sell the inventory. This is calculated by taking the inventory balance and dividing by the average daily cost of goods sold.
DPO involves the length of time it takes to pay vendors. DPO is calculated by taking the trade payable balance and dividing by the average daily cost of goods sold.
The key value of this exercise is to measure the liquidity risk required for growth. Measuring the cash conversion cycle at any given point of time provides a hard number which by itself has little meaning. It needs to be compared with past performance of the organization to set a baseline so that future planning is meaningful. The question arises, what happens if vendors start to require a quicker payment schedule? Inventory is going to be held for a longer period of time due to changes in the sale cycle, vendor credit limits will restrict larger sales or cause problems in the cyclical nature of the business, customers pay slower, etc. The management of the cash conversion cycle has a tremendous impact on the organization's financial health and will assist in determining if growth can be supported internally or require the partnership with a financial solution provider.
When partnering is required a managed service agreement is entered into between a supply chain organization and a financial solution provider. Typically, the financial solution provider maintains payment and surety relationships directly with the technology vendors, and the logistics partner has access to product he or she might not otherwise have. In addition, the financial solution provider offers financial administrative oversight and expertise to logistics partners to help ensure that transactions flow properly and in accordance with terms. Ultimately, the vendor payment processing and surety provides a comprehensive solution that eliminates the capital risk and administrative constraints inherent in the supply chain environment.
Source: Global Technology Finance
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