San Francisco, CA (PRWEB) April 17, 2014
It looks like the U.S. is close to the economic turning point when interest rates will likely rise and capital availability may tighten and it may be time to look beyond bank financing to fund business growth.
For private, middle-market companies, the traditional sources of growth capital have been internal capital generation from profits, family and friends and bank lines of credit. But there are other ways to finance the growth of a small business; interest free and without borrowing money.
The most successful businesses in the U.S. utilize “Other Peoples Money,” primarily from suppliers and customers, to maximize cash flow and avoid incurring debt to finance business operations. Two terms that these companies are very familiar with and every small business should know are “Cash Conversion Cycle” and “Corporate Trade Credits”.
The Cash Conversion Cycle
The Cash Conversion Cycle measures how long a company will be without cash because it has spent cash, for instance on inventory, in order to expand customer sales. It is essentially a measure of the liquidity risk created by growth and the expense of cash as a result of the growth of the business. Many companies often wonder why their business is growing but they are always short of cash – the Cash Conversion Cycle is the reason.
When companies take an extended period of time to collect outstanding bills, or overproduce inventory, the Cash Conversion Cycle measured in days lengthens. More inventories purchased means less cash available. For small businesses without large credit lines, a long Cash Conversion Cycle can mean the difference between success or failure as the business has to pay debts to vendors for inventory or services faster than it is receiving cash from its customers.
The Cash Conversion Cycle calculates the time it takes to convert inventory into cash. It is composed of three categories: days sales outstanding, days payable outstanding and days inventory outstanding. Days sales outstanding is the amount of time a company takes, on average, to collect bills. Days payable outstanding is a firm's average period of time to pay bills. Days inventory outstanding is the amount of time, on average, a firm takes to convert inventory to sales.
To calculate the length of the cycle, add days inventory outstanding to days sales outstanding, then subtract days payable outstanding. The lower the number, the more efficient is the business.
Credit payment terms for each customer should be based on reports by customer as well as the cycle measured at the entity level. Trade discounts can be given to slower paying customers while “better” customers may receive no discount for early payment. Seems like a contradiction to offer slow pay customers a “deal” but it is an effective way to accelerate cash collections.
Some companies even achieve negative days by shipping directly from the supplier to the customer, arranging terms where the supplier provides credit but the customer pays in cash or turning over inventory so quickly that it is sold before the seller has to pay for it. Best Buy, a leading retailer of technology products, achieved an significant negative Cash Conversion Cycle when High Definition TVs were flying off the shelves in the early days of product introduction.
Using Corporate Trade Credits
The second term relevant to financing rowing companies is the Corporate Trade Credit. Corporate Trade Credit is the largest use of capital for a majority of business to business sellers in the United States and is a critical source of capital for a majority of all businesses. Wal-Mart, the largest retailer in the world, has used trade credits as a larger source of capital than bank borrowings; trade credit for Wal-Mart is 8 times the amount of capital invested by shareholders. Corporate Trade Credits are arranged at the time of negotiating with a vendor or new supplier while the Cash Conversion Cycle is generally viewed as the ongoing management of the company’s cash flow. Trade credits facilitate the purchase and sale of good without the immediate transfer of cash. Payment terms, form of payment and credit limits are all subject to negotiation.
The Cash Conversion Cycle and Corporate Trade Credit concepts can be very valuable to growing companies. Become familiar with both concepts and implement solutions that will help self finance your business.
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Michael Evans is the Northern California Managing Director of the Newport Board Group. (415) 990-1844