Cash Flow Matters: Tackling Inefficiencies in the Cash Conversion Funnel
The cash conversion cycle is critical for liquidity but often suffers from leaks in key areas. Smarter inventory strategies, optimised payment terms, and collaborative planning can help CFOs reduce inefficiencies and maintain financial stability.
We like to think of the cash conversion cycle as a funnel: inventory enters at the top, and cash flows out from customer payments at the bottom. The goal is to keep this funnel flowing efficiently.
But, as with any funnel, leaks are inevitable, which impacts your cash flow. These leaks manifest as inefficiencies in managing inventory, collecting payments, or paying suppliers. They can quietly drain your resources and extend your cash conversion cycle.
Frequently, the inventory component of the cycle (Days Inventory Outstanding or DIO) gets the lion’s share of attention. However, focused attention on leaks that can occur when you’re collecting money from customers (Days Sales Outstanding or DSO) and paying your own accounts (Days Payable Outstanding or DPO) can also yield significant improvements. We’ve seen a range of organisations shave days off their cash conversion cycle by implementing one or more of the strategies we’ve outlined below.
Inventory strategies
It’s a scenario that may be familiar. Let’s say your procurement department has negotiated a favourable unit price of $1, with the condition that your minimum order quantity is 1000. Meanwhile, a deeper conversation with the supplier secures a unit price of $1.05, with a smaller order quantity of 100. Which one is the better deal?
If you’re regularly moving 1000 units, then the first option is the clear winner. However, what if demand has decreased, and you’re holding onto the stock for longer before converting it into sales. Not only do you need to factor in the warehousing costs; there will also be an impact on your cash conversion cycle as it’s taking longer to convert stock into revenue.
Essentially, it’s a game of trade-offs, or balancing the minimum order quantity and economic quantity. Increasing your cash flow at the expense of a slightly reduced margin might make sense for a particular product line – and for others, it may not.
There is a significant caveat here. Inventory trade-offs are a difficult game to play if you’re in a heavily siloed organisation, where different departments have different (and even conflicting) KPIs. Your procurement team might have performance measures based on negotiating the most favourable unit cost, without necessarily having a view on the longer-term financial metrics such as the cash conversion cycle.
The solution is to work on strengthening your integrated business planning (IBP) process, with a particular focus on heading towards Stage Four maturity. Balanced and collaborative conversations with suppliers and internal stakeholders, supported by planning tools that are sophisticated enough to model a range of outcomes, will give you a much better chance of achieving win-win outcomes.
The power of customer segmentation
Next, plugging the leaks in the DSO component of your cash conversion cycle comes down to one critical activity: customer segmentation.
Longer payment terms and late- (and non-) paying customers can both have a negative impact on the overall cycle. To combat this, it’s useful to undertake a customer segmentation exercise, for example:
You might decide that Class A, your priority customers, can have 60-day payment terms, while Class C might be on 30 days to support your cash flow. Bear in mind that favourable terms might also include shipping terms. For instance, you may be able to negotiate for your customer to take ownership of your goods at Port A (earlier in shipping) rather than Port B for a slightly better price, with the invoice issued when goods are received.
Also worth considering are pay-on-time (or early) discounts to offset your cost of working capital – as little as 2% can improve the cash conversion cycle. With the right tools, it’s even possible to build out a more complex matrix of customers and product lines and consider discounts on particular customers for particular product lines.
Customer segmentation exercises and the decisions that result from them should always be a collaborative effort between the Finance and Customer Relationship teams. The right planning tools will give you useful insights about customer profitability, but human eyes are almost always required to ensure you arrive at the right decisions in terms of long-term customer potential.
Optimising supplier payment terms
If you need to seal up DPO leaks, we need to flip the previous conversation on its head. Here, the aim is to optimise the payment terms you have with your own suppliers – essentially, you’re looking to have your customers funding your day-to-day operations, rather than borrowing capital.
Similar to your inventory discussion, this is all about collaboration and negotiations with key suppliers and internal stakeholders about your most important products. For example, a supplier may give you more favourable payment terms (days payable and/or shipping) if you give them more volume. Cost may also be a consideration – is it worth trading off a slightly higher unit price for longer payment terms, which will improve your cash conversion cycle?
While humans will take the lead in critical thinking and negotiations, accurate and reliable spend analysis data will anchor the conversation. A planning tool that can model various scenarios will also support the process.
For example, your data may be telling you that you should negotiate with one supplier to consolidate your spend for a better price or payment terms, but how would that affect your inventory projection or cost of goods sold?
Finally, it’s also worth revisiting your supplier management program. Open scorecards that rate your suppliers on factors such as price, ability to deliver on time and in full, and quality help to drive visibility and healthy competition.
Collaborate to stop the leaks
Ultimately, reducing inefficiencies in the cash conversion cycle almost always comes down to balancing the right trade-offs. Whether through smarter inventory management, targeted customer segmentation, or optimising supplier payment terms, it’s possible to plug the leaks in your funnel.
The right combination of data-driven insights and collaboration to make better decisions will help maintain healthy cash flow and long-term financial stability.
