When valuing a business, the Cash Cycle is still one of the first KPI’s reviewed after reviewing margins and earnings. It is a simple calculation that few businesses and few accountants appear to report on notwithstanding its simplicity.
Generally, return on asset and return on investment measures are too often forgotten by privately owned businesses, particularly successful mature businesses. Balance sheets can become lazy and cash that could otherwise be returned to owners is tied up in debtors and inventory. Dangerously, as the amount of cash tied up in debtors and inventory increases the risk of realising full value diminishes.
Set out below is a brief analysis of the calculation of the Cash Conversion Cycle, the difference in share price performance of some the largest retailers in the world compared to their Cash Conversion Cycle and the impact of the Cash Conversion Cycle on the goodwill of an enterprise.
The Cash Conversion Cycle Measure
What is the amount of time between a business spending cash and receiving cash for each sale or expressed in another way, how long is cash tied up in working capital?
The Cash Conversion Cycle is made up of a number of simple calculations. It is a combination of calculating Inventory Days plus Accounts Receivable Days less Accounts Payable Days.
Cash Conversion Cycle and Maximising Value
In 2012, Forbes magazine published an article on the Cash Conversion Cycle of four major retailers:-Walmart, Target, Costco and Amazon (the Cash Conversion Cycle 10/3/2012 by YCharts). It found that the share price of those with the fastest cash cycle outperformed the share prices of those with a slower cash cycle.
Walmart, then a US$1.2billion dollar a day business had a cash cycle of 10 days. Perhaps not unsurprisingly it found that Amazon’s cash cycle was superior to its competitors. Amazon was reported to have a cash flow cycle of negative 14 days, that is, as it expanded, its working capital requirement was reducing.
Amazon’s Cash Cycle was made up of the following: – Inventory days of 28.9, Receivable days of 10.6 and Accounts payable days of 54 days. The five year share price performance of the four companies was analysed and that performance was exactly in order of the companies’ Cash Conversion Cycle.
Cash Conversion Cycle and Maximizing Goodwill
Reducing the Cash Cycle can release cash flow and increase goodwill.
Two businesses are compared, each generating EBIT of $50 with an enterprise value of $150. Tweaked Enterprise has a cash cycle of 29 days compared to Cumfy Enterprise’s 47 days. This is as a result of faster receivables collection, increased inventory turn (less inventory required for the same level of sales) and negotiation of more favourable credit terms.
Tweaked Enterprise has $15 less in Net Operating Assets than Cumfy Enterprise and Goodwill of $50 compared to Cumfy’s $35. Furthermore, the owners of Tweak Enterprise have an extra $15 in their pocket.
Cash in Now
Now is the perfect time for accountants to be teaching clients about this simple measure that can add value and reduce risk.
Volatility in assets is increasing worldwide. The price of money is rapidly increasing from its record lows. US Fed Funds Rate is 600% higher at 1.75%, compared to its low of 0.25% just two years ago and predicted to increase again in June. Worldwide the talk is of expansion, capacity constraints, tightening labour markets, tightening of monetary policy and increases in inflation expectations is replacing the post GFC hangover talk.
Many opportunities are present for business owners and investors. Alongside margins and earnings Cash Flow Cycle reporting should be at the forefront of accounting reports. To effectively measure the risk of too much money tied up in receivables and inventory this reporting should be done at least annually, if not monthly.
After all, cash is king!
Mark Bailey is an Associate Director at Hall Chadwick Forensics in Melbourne. He has over 25 years’ experience as a Chartered Accountant specialising in business valuation services, compulsory acquisition and commercial disputes.
Contact Mark firstname.lastname@example.org or call Hall Chadwick Forensics on 03 9820 6400.