A few years back, as I was onboarding a new client, we started talking about cash. “We’re profitable, but where is the cash?!?” he asked.
It’s a great question. And a question I’ve heard more than a few times since in this form or others.
Why can’t I make payroll?
I can’t afford my next run of inventory… what gives?
These taxes are killing me. How can I pay them if I don’t have money?
These are all a root of the same problem (repeat after me): Profit ≠ Cash.
Almost all those who asked me this question had profitable businesses. Yet they were confounded by the exact same thing.
The reality is that very few businesses and business owners understand their cash flow.
This is where the Cash Conversion Cycle comes in. It helps us see why cash disappears in ALL businesses and how to fix it by managing AR, inventory, and vendor payments.
Let’s walk through an example to make this more easily understandable.
YOUR CASH IS TRAPPED
Widget Co buys 100 units of Widget A for $1,000 on April 30th.
They have to pay for the widgets when they buy them, so they have $1,000 going out the door.
Then, 5 days later, they sell 47 units for $22/piece. But sold does not mean PAID. So they show “Revenue” but no incoming cash. That doesn’t come until 30 days later when the customer pays (assuming they do).
So, $1,000 of inventory are bought on April 30th, but no cash comes in the door until June 4th. But even then, you’ve only broken even… there’s not enough cash to buy your next inventory run.
That happens when you sell 44 more units on May 25th, which you don’t get paid on till June 24th.
After buying that 2nd round of inventory, on July 30th (assuming no more sales), you have $2 in the bank but show $1,092 in profit.
WHERE’D THE CASH GO? Back into inventory…
You can see where this cycle, if not managed well, can be exhausting for business owners.
AND GROWTH MAKES IT EVEN WORSE
Now imagine demand has increased… as growth happens, stress on cash compounds.
Say instead of 47 & 44 purchase happening 20 days apart, they happen 7 days apart.
After 7 days you’ve sold through inventory, but won’t get paid enough capital to purchase more for another 30 days.
Then you sell through that batch in 10 days… and wait 30 more before you can buy again. It’s not until you’ve gone through this cycle a few times that you have generated enough profits to pay for inventory sooner, but even then this is a dream… meaning theory is often wrong. Because there are other expenses too.
In this case, the only way to keep up with growth is to take on debt, which means more expense in the way of credit expenses. So great! You can buy inventory, but your break even is moved even further down the line.
In the promise of volume, you’ve sold a portion of your profits.
The key to understanding this cycle is understand a fun little formula: cash conversion cycle.
INTRO TO THE CASH CONVERSION CYCLE
Cash conversion cycle, simply defined, is the time between spending a dollar and getting it back.
It’s made up of three variables:
- DSO: Days Sales Outstanding (AR)
- DIO: Days Inventory Outstanding (Inventory)
- DPO: Days Payable Outstanding (AP)
The calculation is CCC = DIO + DSO - DPO
In the example we gave above (Scenario A), it works like this:
- bought and paid for our inventory on the same day (DPO = 0 days)
- held the inventory for 10 days before sold (DIO = 10 days)
- were paid 30 days after sale (DSO = 30 days)
So, our CCC = 10 + 30 - 0 = 40 days.
Now let’s look at each of these independently.
DIO = DAYS INVENTORY OUTSTANDING
DIO = Average Inventory / Cost of Goods Sold (COGS) x 365 days
In short, it answers how many days does it take you to sell through purchased inventory.
A high DIO means inventory is not getting sold quickly, which can be from overstocking or a slowing of sales.
Improve (by decreasing it) your DIO by:
- Refining your inventory forecasting
- Order in smaller quantities, but more frequently
- Improve inventory tracking and management once onsite
- Getting rid of slower-moving and lower margin products
- Starting a marketing initiative that increases demand
But, you have to balance this with keeping the right inventory levels. Decrease it too much and you’re likely not keeping enough inventory in stock, which will put stress on your operations. Look at industry averages and understand where you are in comparison to your peers.
DSO = DAYS SALES OUTSTANDING
DSO = Account Receivables / Sales x 365 days
In short, it answers how many days it takes you to collect money from customers.
If you collect money at the sale, your DSO is zero. If you have a standard 30 day term, your DSO will be closer to this number. A high DSO (> 45 days) means you’re not collecting your money and could be a sign of bad processes or less control over your terms with customers.
To improve your DSO:
- Create or improve your customer credit evaluation process
- Shorten the time between delivery and invoice creation
- Manage your accounts receivable proactively
- Reduce customer payment terms
- Accept more forms of payment
- Offer early-pay discounts
- Ditch late payers
So, let’s run a scenario. Say the customer now has to pay when they buy. This takes your DSO from 30 days to 0 days.
So, adjusting Scenario A, our CCC = 10 + 0 - 0 = 10 days
Pretty, pretty good!
Now, by May 25th we have enough cash to rebuy without running out of cash and if we sell at the same rate can rebuy again by July 14th.
DPO = DAYS PAYABLE OUTSTANDING
DPO = Account Payables / COGS x 365 days
In short, it answers how many days it takes you to pay your bills.
An increasing DPO means you’re slowing down payment, which can be good or bad depending on WHY. If you’re slowing down to intentionally improve your CCC, fine. But if you’re slowing down because of cash flow problems and start paying people late, this is a big cause for concern.
You’ll notice this includes all payables, not just inventory-related payables. You’re not just limited to the sales cycle, as you can reevaluate how you pay ALL your vendors.
To improve your DPO:
- Pay your bills no earlier than 7 days before the due date
- Pay invoices (at due date) on credit cards, extending terms another 30-45 days
- Negotiate better terms (it’s as simple as asking)
Now imagine you had 30-day payment terms from your supplier on inventory. This takes your DPO from 0 days to 30 days.
So, using Scenario A as our starting point, our CCC = 10 + 30 - 30 = 10 days
This shortens the cash gap, but you’re still relying on having the cash upfront.
THE GAME CHANGER
So what if we combine Scenarios B & C above? We take 30 day terms from the supplier and get paid up front?
Now, our CCC = 10 + 0 - 30 = NEGATIVE 20 days
Where in previous scenarios you were cash-constrained, the negative CCC allows you to keep buying inventory and scaling without a cash constraint. You can now turn inventory 3x in this 3 month period instead of 1x as in Scenario A.
You’re actually getting cash from the revenue quick enough to pay for the inventory you purchased.
This completely changes the relationship between the business and money! Growth no longer depletes cash, it fuels it. That’s the difference between scraping by and scaling fast.
Game changer!
When you start to understand the cash conversion cycle, you can start to look for ways to “game” each element.
- How can you decrease the time you hold inventory?
- How can you collect money faster from your customers?
- How can delay your payment (ethically) to the vendor?
In the 3 scenarios we referenced above, you can see how you go from having 1 inventory turnover in Scenario A, to 2 in Scenario B & C, to 3 in Scenario C.
It’s only when inventory turns that cash balances converge again. But remember: they’re converging because they’re scaling.
This directly affects how quickly you can scale as a business.
When we compare the 3 scenarios on July 31st, Scenario C has 5x the cash balance of A and 2.5x the balance of B.
INDUSTRY VARIATIONS
It’s easy to look at CCC as a service business and think “we don’t have inventory, so it doesn’t matter.” But, there are ways to still learn from this concept.
For service businesses, replace DIO with service delivery to invoice days (or notice to customer).
Do the work on October 4th but don’t invoice until the 31st? That’s a 27 day “DIO” that could be improved.
If the service delivery is an employee hour, you can also replace DPO with the employee’s payroll date.
For example:
- Work done: 4/1/25
- Payroll ran: 4/11/25
- Invoice created: 4/30/25
- Payment received: 5/28/25
Using the CCC concept, your CCC would be 47 days (29 + 28 - 10) or the difference between 4/11/25 and 5/28/25.
Also, different industries will have different norms.
- Service: Low DIO, moderate DSO
- Product: Higher DIO, focus on DPO
- Construction: Wild variation; cash tied in WIP
Look at your industry norms, as well as customer type (big versus small).
NEXT STEPS
Take some time this week to ask the following questions:
- How can you decrease the time you hold inventory?
- How can you collect money faster from your customers?
- How can delay your payment (ethically) to the vendor?
Actually map out your cycle and look for lags between steps.
It’s amazing how little norms within the business can really put pressure on cash. Just slight adjustments can make a world of difference, often with only small impacts to your team.
After you do it, I’d love to hear: what did you find? Where are you planning on implementing some new things?
If you need help, don’t hesitate to reach out. This is part of a process we do with all new clients and we’d love to help you! Just let me know by replying to this email.
Now that we better understand the flow of cash, next week we’ll talk about: “How Much Cash Should You Actually Have?”
