Analysis and Management
Useful Performance Measures for Improving Profitability
D. Hutchison, M. Theodore Farris II, and Susan B. Anders
AUGUST 2007 - There
is a growing demand among companies for help in managing the cash
flow cycle: accounts payable to inventory to accounts receivable.
Managers must know their company’s cash-to-cash (C2C) position,
and not focus solely on bottom-line profits. With financial data
and computer technology readily available for assistance, any company,
or its business advisor, can easily determine its C2C and develop
benchmarks for comparisons. Companies can take a broader view of
the supply chain, which will help them in negotiating terms for
accounts payable with suppliers and accounts receivable with customers,
as well as in balancing supply chain transactions to obtain overall
efficiencies and improved profits for all parties. Cash-to-cash
analysis represents an excellent opportunity for accountants to
expand their portfolio of value-added skills.
C2C is a
unique financial performance metric that indicates how well an
entity is managing its capital. The definition of C2C, or cash
conversion cycle, is “the length of time a company’s
cash is tied up in working capital before that money is finally
returned when customers pay for the products sold or services
rendered” (Neil C. Churchill and John W. Mullins, “How
Fast Can Your Company Afford To Grow?,” Harvard Business
Review, May 2001). Admittedly, this definition ignores depreciation
and places income taxes within operating expenses; however, the
computation of standardized variables for multiple-company data
serves as an excellent benchmark to help guide improvements within
an individual company and across the supply chain.
both purchases and sales are involved in C2C, three key variables
are in the calculation: inventory, accounts receivable (A/R),
and accounts payable (A/P). A company’s historical data
are typically used to compute the C2C variables. Experience has
shown that using medians may be preferable to using means, in
order to avoid an undue influence of outlier data points. These
variables must be standardized to a common measure, using the
= Inventory/Cost of Goods Sold x 365 Receivables(C2C) = A/R/Net
Sales x 365
Payables(C2C) = A/P/Cost of Goods Sold x 365
is calculated for the company using these three variables:
C2C = Inventory(C2C)
+ Receivables(C2C) -Payables(C2C)
standardize the data into days. The final C2C figure may be positive
or negative. A positive result indicates the number of days a
company must borrow or tie up capital while awaiting payment from
a customer. A negative result indicates the number of days a company
has received cash from sales before it must pay its suppliers
for inventory. Ultimately, the goal for most companies is a C2C
that is as low (or even negative) as is reasonable for a company
in that particular industry. A lower C2C suggests that a company
is more efficient in managing its cash flows, because it turns
its working capital over more times per year and generates more
sales per dollar invested. It is important to understand that
the C2C calculation technique assumes that cycle time may be shortened
without a resulting increase in costs or decrease in sales [Luc
A. Soenen, “Cash Conversion Cycle and Corporate Profitability,”
Journal of Cash Management 13 (4), 1993].
may focus on any combination of the three key variables to improve
their C2C: reduction of inventory days, reduction of accounts
receivable collection days, and expansion of accounts payable
days. It is difficult to estimate the effect of a change from
adjusting an individual variable, because all three are interrelated,
but improving any one will resort in a shorter C2C cycle for a
of C2C Analysis
are aware of the merits of computing C2C. The underlying attraction
of reducing the C2C cycle is that it will lead to operational
and financial improvements. Each business seeks to obtain a proper
mix between the amount of resources deployed to working capital
and those to capital investments. Thus, there is an ongoing trade-off
between operational decisions to lengthen the C2C cycle (which
increases the liquidity required) and financial decisions to shorten
the cycle (which decreases the liquidity required).
To stay in
business, a company must not only operate at a profit, but decision
makers must also manage its cash effectively. The question arises:
Are profitability and cash management related? While it is not
possible to answer this question definitively for all companies,
a review of 12 years of data from the Research Insight 7.6 database
of more than 22,000 public companies indicated a direct correlation
between shorter C2C cycles and higher profitability for 75% of
available for operations has a multiplier effect based on cash
turnover, C2C also influences the maximum attainable profit for
a firm (Peter Skomorowsky, “The Cash to Cash Cycle and Net
Income,” The CPA Journal, January 1988). A shorter
C2C cycle results in a higher present value of net cash flows
generated by the assets and, ultimately, a higher value for the
benefits may be substantial, depending on which C2C variable is
improved. Benefits may include: a one-time increase in cash from
the conversion of inventories or receivables into cash, or from
delay of payment of accounts payable; and reducing significant
ongoing expenses such as the weighted-average cost of capital
(WACC) and inventory carrying costs (ICC). Each business is unique;
however, the following case study may help illuminate how to specifically
identify potential cost savings.
C2C as a Benchmark
seeking to improve the supply chain interaction with their suppliers
and customers may use C2C as a benchmark to begin investigating
opportunities. The process for improvement includes:
1: Determine C2C variables for the company, as well as for competitors
in the same industry.
2: Benchmark the company’s position relative to its industry.
Compare company performance and determine where there are large
differences from industry leaders.
3: Quantify the value of changing one day for each variable.
4: Determine C2C variables for key suppliers and customers.
5: Identify where there are significant differences between
trading partners for offsetting variables (accounts receivable
versus accounts payable).
6: Determine the financial impact of aligning (changing) the
offsetting variables and seek a mutually beneficial improvement
with trading partners.
In the past,
it was difficult to obtain financial data from other companies
and devise benchmarks. Today, these data are readily available
and computer technology expedites the computation of any public
company’s C2C (see Exhibit
1). Data may also be grouped by Standard Industrial Classification
(SIC) or North American Industry Classification System (NAICS)
codes to allow companies to create industry benchmarks. SIC codes
were used in this case study to identify longer historical trends.
problem was that companies could calculate their C2C, but the
result had very little practical application for negotiations
with suppliers and customers. Today, companies using C2C data
have better negotiating positions with suppliers and customers,
because the data are readily available. In supply chain management,
C2C also allows companies to begin to examine the supply chain
from a broader view, beyond the company-level view. Businesses
are viewing C2C as a bridge between inbound material activities
with suppliers and outbound sales activities with customers.
the application of C2C analysis at the company level, a large
international firm in the “Semiconductor, related devices”
industry (SIC 3674) was selected, referred to here as Company
X. Financial data for 1999 through 2005 were obtained from the
Research Insight database, as described above. In order to calculate
meaningful benchmark numbers, any companies with incomplete or
extreme outlying data were deleted from the dataset.
step is to determine Company X’s C2C. Exhibit
2 shows Company X’s financial data from 1999 through
2005. Next, inventory, accounts receivable, and accounts payable
are converted into a common measure of days, using the equations
above, as shown in Exhibit
3. These variables are then used to calculate annual C2C.
4 shows that while C2C days remained relatively constant (except
for 2004, due to a degradation in accounts payable), the individual
variables have changed. Inventory days increased slightly in the
most recent years, accounts receivable days steadily decreased,
and accounts payable days were mixed but trended downward.
of an individual firm’s C2C is helpful, industry benchmarks
are crucial for a company to evaluate its C2C performance and
assess opportunities for improvement. For the semiconductor industry,
benchmark data in Exhibit
5 may be examined in multiple ways. Company X is ranked 99
out of 147 companies in this industry for C2C. Company X is performing
better than the industry median for inventory and accounts receivable;
however, its accounts payable is below the industry median by
21.7 days; that is, the company pays its bills 21.7 days faster
than is expected in the industry.
can also be compared against the industry leader, which has a
lower inventory by 11.2 days, a shorter accounts receivable by
9.9 days, and a longer accounts payable by 155.3 days. It has
an overall C2C advantage of 176.4 days, due largely to its lengthy
companies in the first quartile of the industry possess a lower
inventory by 16.8 days, a shorter accounts receivable by 9.9 days,
and a longer accounts payable by 44.8 days, when collectively
compared to Company X. First-quartile companies surpass Company
X’s C2C cycle by 71.5 days. Company X’s accounts payable
days are negatively impacting its C2C, in comparison to benchmarked
of these results to the top half of the industry would reveal
that Company X holds inventory too long, its collection of receivables
could be improved, and its payables to suppliers could be lengthened
considerably. Uncovering these facts can help Company X explore
actions that could adjust its C2C relative to the better performers
in the industry.
these benchmark results suggest that Company X’s C2C could
be improved. The initial emphasis should be on increasing accounts
payable days to fall in line with industry performance. These
changes must be balanced with continued effort to maintain or
improve accounts receivable and inventory days.
supply chain view of Company X’s C2C position can be ascertained
by examining its five largest suppliers and customers. Even if
Company X elects not to change its C2C mix, it is still going
to be impacted by the actions of its suppliers and customers and
their efforts to improve their own C2C positions.
C2C performance of Company X’s top suppliers and customers
over the most recent four years is presented in Exhibit
6 and Exhibit
7. (Complete data for the suppliers and customers are available
from the authors upon request.) It should be noted that Company
X represents only one customer/supplier to each of these firms.
Most of the suppliers had significant improvements in their C2C.
Overall, these suppliers reduced their C2C by 27.3% in the time
period examined, which was accomplished primarily by reductions
in inventory and accounts receivable.
the average supplier’s accounts receivable correspond to
changes in Company X’s accounts payable. Over the four-year
period, suppliers’ accounts receivable improved an average
of 21.8%. This improvement was at the expense of Company X and
its own C2C position, as evidenced by the decrease in accounts
payable days. The accounts receivable variables for Company X’s
five largest suppliers averaged 84.3, 81.5, 68.6, 51.7, and 43.7
days, in comparison to Company X’s 2005 accounts payable
of 49.0 days. This indicates that Company X may be able to extend
its accounts payable days to these suppliers.
reflects the C2C improvement by Company X’s customers. The
average customer C2C decreased 33.4% (39.5%, if the outlier Customer
A is not considered). Over the four-year period, the average customers’
accounts payable extended 2.5 days. With the exception of Customer
A (whose C2C degraded in 2005 due to significant inventory problems),
all of the companies presented showed an improvement in their
C2C over this time period. This improvement directly affects Company
X and its accounts receivable.
Company X’s suppliers significantly improved their accounts
receivable, while Company X’s customers improved their accounts
payable. These changes had a direct impact on Company X financially.
Both contributed to the declining C2C position for Company X,
which was able to mitigate some of these changes by improving
its inventory days.
Analysis for C2C Improvements
X, there are benefits to be realized from examining its C2C and
seeking improvements. Exhibit
8 presents the paybacks.
Analysis of Company X's C2C variables reflects that one day of
Company X's inventory is valued at $15.3 million. Reducing inventories
by one day of supply represents a one-time conversion of $15.3
million in cash. In addition, assuming an inventory carrying cost
of 25% per year, the reduction in inventory will reduce annual
inventory carrying cost expenses by $3.8 million each year. Similarly,
Company X has daily receivables revenues of $36.7 million. If
the company can speed up its receivables by one day, it will result
in a one-time infusion of over $36.7 million. The annual benefit
of converting a day of receivables into cash, assuming a weighted-average
cost of capital of 12%, would be to generate (or avoid) $4.4 million
in interest annually. Company X should consider the benefits in
aligning its payables to better match industry performance, which
is a median 21.7 days longer than Company X’s performance.
Extending payables by one day would result in a one-time cash
retention of $15.3 million, which can also generate (or avoid)
$1.8 million in interest annually. The upside potential of this
change is a cash infusion of more than $332 million (21.7 days
x $15.3 million) and annual ongoing savings (or interest avoidance)
of over $39 million (21.7 days x $15.3 million x 12% cost of capital).
It is not
enough for a company to formulate a cash-to-cash analysis; it
must also utilize data and technology to improve its C2C efficiency
and, thus, profitability. Management must understand the role
of the C2C variables (inventory, accounts receivable, and accounts
payable) and their leverage points, and regularly monitor all
changes, internally and externally, with respect to its suppliers
and customers. Also, it is important to calculate competition
and industry C2C benchmarks to help improve company performance.
C2C analysis can also provide a basis for identifying areas of
opportunity to guide strategic goals for improvement.
D. Hutchison, PhD, is an associate professor of accounting
in the department of accounting, University of North Texas, Denton,
M. Theodore Farris II, PhD, CTL, is an associate
professor of logistics in the department of marketing and logistics,
also at the University of North Texas.
Susan B. Anders, PhD, CPA, is a professor of accounting
in the school of business, St. Bonaventure University, St. Bonaventure,
N.Y., and a member of The CPA Journal Editorial Board.