An Explanation of the Cash To Cash Cycle

Let’s go through an explanation of the cash to cash cycle:

 

A business will usually make a decision to purchase raw materials or services once its has made a decision to make product or provide a service.  The old adage that it “takes money to make money” is paramount here.  Let’s assume a business will make a product.  The business will need an order from a customer; it will need to buy raw materials (which is account payables and inventory), formulate a manufacturing process to make the product, sell the product (which is an account receivable), and receive final compensation for the product (cash).  While the business is making products, it is still incurring expenses such as payroll, buying inventory and equipment, operating a facility, and so on. 

 These expenses consume cash.  Preferably, a business would desire to collect its cash from its customers before its expenses were due.  This does not happen very often in business, which then forces a business to incur more finance costs by borrowing on a credit card or line of credit until it receives its cash.  This finance cost ultimately ends up into the final cost for a product or service.  The longer the gap between a business spending its cash and collecting its cash, the more finance costs it will incur.

How does the supply chain play a role in solving this problem?  The supply chain plays a huge role in this cycle.  For instance, what happens if products do not get made on time for customers?  What happens if there is a bad forecast and too much inventory is made?  What happens if one of a business’ key suppliers goes out of business?  What happens if a key customer goes out of business?  What happens if a manufacturing facility is damaged and cannot operate?  All of these supply chain issues have an impact on the firm’s cash to cash cycle and ultimately its overall cash flow.  Cash Flow is analogous to blood in the human body; just as a human being will die when loosing too much blood, a firm without an agile and nimble supply chain can suffer huge impacts on revenues and costs, which will cause it to loose a lot of cash (blood) and in turn make its insolvent (unable to meet its current obligations) and ultimately make it go out of business (die). 

As one can see, it is very important to manage the supply chain and its effects on the cash to cash cycle.  If a firm does not manage its supply chain properly, it will ultimately go out of business.  Delays in the supply chain affect the C2C cycle which affect the amount of working capital in the business and ultimately the financial health of the business.

 In order to understand how the supply chain affects the cash to cash cycle and the health of the business, one must take a look into how the supply chin affects A/R, A/P, and inventory.

 First, we must begin by understanding the concept called “working capital”.   Basically, working capital is the amount of capital it takes to run the business.   As we stated before, one tries to match cash flows with outgoing expenses; working capital is that amount of capital that makes up the gap it takes to run the business.  The more efficient the cash flows are, the less working capital it takes to run the business.   The accounting equation used to express working capital is Current Assets – Current Liabilities.  Current assets (by order of liquidity) include cash, accounts receivable, inventory, and prepaid expenses.  Basically, current assets are those assets which will be used by a business in one year ore less.  Current liabilities include accounts payable, short term expenses, short term debt and accrued expenses.  Basically, current liabilities are those obligations of a business due within a year.    The working capital equation basically says that a business should have has more assets that will turn into cash in one year that obligations that will come due within a year.  Working capital should be positive, except in the case of the Dell Computer Model, where it receives its cash instantly and can take up to 90 days to pay suppliers.  We call this “negative” working capital, but the term is good because cash is coming in at a much faster rate than cash going out of the business.

 Out first working capital equation is known as the “practical” method because it is easily identifiable on the balance sheet and easy to calculate.  There is also a method called the “conceptual” method which uses the accounting equation and the practical working capital equation to discern how current assets are financed in the firm.  Here is a breakdown of this equation:

         WC (The Conceptual Method)

–        Assets = Liabilities + O/E

–        Cur Assets + LT Assets = Cur Liab + LT Liab + O/E

–        Cur Assets – Cur Liab = LT Liab + O/E – LT Assets

–        WC is supported by Cur Liab and some portion of LT Debt and O/E

 

As one can see, a firm supports its working capital needs (assets) through a combination of short-term debt, trade credit, as well as long-term liabilities and equity in the firm.  Basically this can consist on how much debt the firm incurs, how much the firm earns through its operations, and how much equity capital a firm raises. 

 

The way an effective supply chain affects working capital is that when customer requirements are met, the firm will incur more business and increased sales.  A firm who manages a lean supply chain cuts expenses, which creates more earnings and increases equity through increased retained earnings.  An effective supply chain allows for better use conversion of A/R and inventory (current assets), which decreases the need for working capital and frees up cash to be used in other areas of the business.  When cash is freed up, then there is less of a need for debt financing, which ultimately lowers supply chain costs.  Managing the cash to cycle with an effective supply chain will improve the financial health of a firm through lower costs and improved financial liquidity, profitability, and solvency.

 Now that we can better understand the impact of the supply chain on the firm, it is important to observe what supply chain activities affect the cash to cash (C2C) cycle.  We know that the C2C equation is A/R + Inv – AP, so it important to identify the activities which affects each of the cash to cash components.