The Second and Third Principles of Happy Cash Flow

May 2007

Principle 2—Cut the number of days in the cycle

This principle says that the fewer days you take to spin the cycle, the better. Shortening the number of days in the cycle ensures that you have maximum use of your own money and that others don’t!

Again, let us compare and contrast. Let’s say you are a homebuilder and it takes you half a year to build a home. So, it may take you 180 days to turn that cycle.
Contrast that to the number of days it takes to turn the cycle at Dell Computer. Their cycle turns several times a day—a thousand times a year. Based on just this principle, where would you rather your dollar be hanging out? DUH.

(The homebuilder is no dummy, of course. They make it on the fourth principle.)

Metrics to measure your success

Now there are three metrics that help us determine how many days it takes to turn the cycle: DSO, DSI, and DPO. These are great metrics for measuring how well you are managing cash. Let’s talk about each one in turn.

DSO stands for Days Sales Outstanding. This measures the time it takes to collect from your customers. And we want this to be as little time as possible.
Looking at the cycle, DSO measures the number of days between the event of shipping and the event of collecting from the customer. In general, when we give credit, we allow our customers 30 days to pay. Some of our customers are going to pay much slower. (By the way, the way you calculate these metrics is included in the appendix to this book.)

Now, Dell, as I told you earlier, wasn’t always so smart—prior to 1996 they used the traditional manufacturing model. Under this model their DSO number was 42. Now it is 34. That is a nice change.

What can you do to collect from your customers faster?

If you wanted to collect from your customers faster, what would you do? There is always your cousin Guido, the strong-arm, who is very persuasive when it comes to collecting.

Other things you can do are:

• Hire more people to call customers to follow-up on late payments
• Use credit cards—credit cards pay in three days
• Invoice customers as quickly and accurately as possible
• Offer discounts for early payment
• Tighten credit policies—allow only customers who are likely to pay the opportunity to do business with you

Think of Wal-Mart here. When I first started shopping at Wal-Mart, they would only take cash or check. No credit cards, because the three days it took them to collect on credit cards was too long.

Why even have sales outstanding at all?

Many businesses avoid outstanding sales altogether. They demand cash on delivery or, even better, demand cash in advance. 

When you buy a bucket of chicken at KFC you pay for it right away—in cash. When you order a wedding gown, you pay the dress shop the entire amount up front—18 weeks in advance of the delivery of the gown. 

Would your customers accept such an arrangement? This way you have their money instead of them having your money. You never know until you ask. They may not mind at all.

The second metric is DSI. This stands for Days Supply of Inventory. This measures how many days worth of raw, in process, and finished goods inventory you have in stock. Now, if you don’t have inventory, I will give you an alternative measure later, when we apply these principles to different industries.

Now, again, we want this number to be as short as possible. A large number may indicate that you are holding too much inventory in a phase of your manufacturing process.

Dell has done an incredible job with this number. Before they implemented their “direct model” their DSI was 31—in 2000 it was 6. Wow!

How can you reduce your inventory?

How can you do this, too?

• Change your sequence of events so that you make only what the customer wants—so you can ship it directly after manufacturing. No storage
• Increase the speed of your manufacturing process so that you hold less
• If you are a retailer, keep a close eye on the inventory items that move and don’t move. The items that don’t move can be returned to the vendor or sold at a discount to get them off the shelves.

The last metric is DPO. DPO stands for Days Payables Outstanding. This measures how long it takes to pay your suppliers. Now, for this number, we want it to be long or big. A big number means that you hold on to your money for as long as you can.

Some businesses make the mistake of paying payables as soon as they get the bill in the mail. We will see in a moment why this is not a best practice.

You can go overboard on this. Organizations that have clout and power can get tough with their vendors.

Dell negotiates with its vendors to pay in 45 days and then pays a little later. The standard length of time most businesses extend for credit purchases is 30 days.
Dell’s DPO in 1996 was near to standard at 33 days. In 2001, the number was 58. Quite an increase.

Dell is even considering raising the number to 80 days.

Why would a vendor put up with this? It is the vendor’s cash at stake here. They are footing the bill and often have to get loans to finance the extra waiting time.

They put up with this because of volume. If you are a company that makes computer memory and Dell is the number one user of computer memory, you may decide you have to sell to Dell.

This does not mean you are getting the raw end of the deal as the vendor, but you do need to be careful to structure your relationship wisely. Here is an example of what not to do.

How not to structure your business relationships

A woman I met in one of my workshops once had a company that made Christmas lights. Her company was based out of Louisiana and one of her specialties was manufacturing Cajun Christmas lights… lights with crawfish and jalapenos.

At the height of the Cajun craze, Wal-Mart approached her company and asked her to put her product in their stores. She was ecstatic. She entered into an agreement with Wal-Mart and went out to get a loan to ramp up production. She created enough lights to meet the demand, and then shipped them out to Wal-Mart.

Unfortunately, the lights did not sell, and after the season was over, Wal-Mart, under the terms of their agreement, returned the lights to her company without paying for them. Her company, of course, was unable to make her loan payments and they went bankrupt. Ew. Not a pretty story.

What to do instead...

What should she have done? Well, she could have asked Wal-Mart to finance her increase in production. Wal-Mart could have paid her up front so that she could have avoided going to a bank for financing.

She could have arranged for Wal-Mart to own the inventory of Christmas lights and for them to have been obligated to pay her for them no matter if they sold or not. She could have also asked for up-front payments for the inventory from Wal-Mart for, let’s say, a third of her cost at the start of the contract, a third at delivery, and then a third at the sale. This way, she would have at least ended up with two thirds of the money.

She may have also wanted to plan for the possibility of the lights not selling at Wal-Mart and negotiated with another retailer to take the lights off her hands when and if they came back to her.

What you CAN do

One woman I know who owns a florist shop is a master at using other people’s money without having a negative impact on her relationship with her vendors. She uses credit cards to do it. 

She purchases her flowers and supplies from the vendor and waits for the vendor to bill her each month. The vendor allows her 30 days of credit. So on the 30th day, she calls the vendor and charges the payment on her credit card.

The credit card company bills her in 20 to 30 days for the purchase and she waits until the final day of the credit card cycle to pay her bill. She stretches the number of days in the cycle without bending any rules or making anyone do without their money. Of course, she uses credit cards to do it, but she feels it is worth it to keep her money for that long.

A more equal arrangement

Or as a vendor, you can insist on a more equal arrangement with your customers. For example a woman in one of my classes told me that she worked for a vitamin manufacturer and sold her vitamins through a major discount retail chain (which ended up going bankrupt in 2002).

This retailer, in an effort to keep up with Wal-Mart, sent her a letter, in a bland, small envelope, that stated that they were going to stretch the payment terms to her to 60 days and take a 10% discount on all future orders. It went on to say that her failure to respond to this letter would constitute her consent to these new conditions. Pretty tricky, huh?

Now this woman was smart. She knew that if she stood against this major retailer alone, they would tell her to take a walk, and they could buy their vitamins elsewhere. She wisely decided to call her competitors and asked them to stand with her to resist these new policies.

Some of her competitors had lost or ignored the letter because it looked so innocuous and were very happy to hear from her. They stood against the retailer and “won”—won to keep the status quo.

We will cover other arrangements and businesses later.

How the metrics add up

Now that we have the three metrics defined, we need to add them up.
DSO + DSI – DPO = TOTAL NUMBER OF DAYS IN THE CASH CONVERSION CYCLE.

This number indicates how long it takes a company to turn an investment of $1 into $1 plus a little profit. Another way to say it is that it counts the number of days in the cycle of converting cash into more cash, hence the title cash conversion cycle.

Wow, this number for Dell went from a positive 40 in 1996 to negative 18 in 2001. Quite a difference! So what does that mean?

Consider what a positive number “1” would mean. It would mean that the company would have to keep one day’s worth of cash on hand at all times and that the sales cycle turns once a day or 360 times a year. So 360 times a year it cranks out its 20 cent profit.

Then what would positive 40 mean? That means that the company would need 40 days of cash on hand and the cycle would spin around 9 times a year. Only 9 times would you get your profit out the back end of the process.

And you know what? That is about average. 30 to 40 days is a “normal” sales cycle.

What does Dell do with all this extra cash? It invests it. So in addition to making profits from selling computers, Dell also makes profits from investing its billions of dollars of extra cash. It also uses the extra cash to grow and to run the business on a day-to-day basis. This leads us to the third principle:

Principle 3—Pump up the volume

Now that we reduced the number of days in the cycle, we need to spin the cycle as frequently as possible. We need velocity! We need to increase the number of transactions. Because every time it spins—cha-ching!—20 cents pops out. YEAH! More profit for us.

Even a homebuilder can use this principle. Even though it takes 180 days to spin the cycle, he can build tens or even hundreds of homes a year. And each time a house closes, he collects profit.

Think of Dell and Wal-Mart. Talk about huge numbers of transactions!

And every time Dell increases market share, as Dell becomes a larger sales organization, as Dell grows as it did over the 1996 to 2000 period from a $5 billion dollar to a $25 billion dollar company—each day of other people’s money it holds is bigger.

Wow, if only we could all have billions of extra cash. Sigh.

Think of the reverse situation. If Dell had allowed other people to use its money, had kept its cash conversion cycle at a positive 40 days while increasing the number of transactions in its business, it would have needed an enormous amount of cash from loans or other sources to run its business.