- June 24, 2020
- Posted by: Brian Post
- Category: Accounting Advice
All too often clients tell me they don’t feel like they are making or seeing the money that their profit and loss statement says they are. There are many reasons why this situation is common for entrepreneurs like pest control operators (PCOs). Thankfully, there is a simple way to help determine if you or your managers are effectively controlling the flow of money in and out of the business. Correctly calculating your business’s cash conversion cycle (CCC) will help you determine if there are steps you can take to collect and preserve cash so unnecessary business woes will be a thing of the past.
Let’s dive deeper into how a business owner can calculate his or her cash conversion cycle and how it can be used as a tool to measure staff performance.
There are three parts to the cash conversion cycle equation. Thankfully, pest control operators are only responsible for calculating two of the three because they don’t need to calculate Days Inventory Outstanding like a manufacturing company would — a pest company’s inventory is not its principle product. This stands true even if you are tracking inventory.
The full CCC equation is:
Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding
Days Inventory Outstanding (DIO)
As mentioned, PCOs do not need to calculate this figure because they are not turning over inventory in the traditional retail sense. Nonetheless, the equation for DIO is as follows:
Days Inventory Outstanding = Average Inventory/Cost of Goods Sold per day
Average Inventory = (Beginning Inventory + Ending Inventory)/2
A smaller number for DIO is preferable.
Days Sales Outstanding (DSO)
Days Sales Outstanding = Average Accounts Receivable/Revenue per day
Revenue per day (monthly) Sales on credit/30
Revenue per day (annually) Sales on credit/365
Average Accounts Receivable = (Beginning Receivables + Ending Receivables)/2
Days Sales Outstanding is the measure of how effective your organization is at collecting money from customers who have been offered terms. When calculating this part of the cash conversion cycle, you must assume that every sale you make to a customer is on credit. It’s easy to assume that all sales are on credit if you operate predominantly in commercial pest control, but it’s a little trickier to calculate if your business favors residential pest control. If you are mainly residential, note what percentage of your sales are made to customers who are on terms or have a credit card on file that you process once service is complete. If you have a high percentage of residential pest control customers with terms, consider changing your customer payment policy to requiring a credit card on file that you run once service is complete, an equal installment plan with a credit card or bank account on file or prepayment for 12 months.
Ideally, the DSO number will be as close to zero as possible, which indicates stellar collections.
Days Payables Outstanding (DPO)
The third part of the cash conversion cycle is calculating Days Payable Outstanding, which you can calculate as follows:
Days Payables Outstanding = Average Accounts Payable/Cost of Goods Sold per day
Average Accounts Payable = (Beginning AP + Ending AP)/2
Unlike DIO and DSO, where smaller numbers are better, it’s most beneficial for a business to use terms provided to them by vendors and to extend the amount of time it takes to pay invoices. This practice helps preserve cash. If DPO causes your cash conversion cycle to turn negative, this outcome means you are achieving a form of interest-free financing from operations. Essentially, you are collecting money from customers before you owe your vendors. This scenario indicates you manage the cash conversion cycle well.
As a best practice, I recommend utilizing the terms provided by a vendor, and then use a credit card to pay the invoice, which will extend actual cash outflow by another 30 days. Also, if a vendor provides you terms such as 2/10 net 30, it’s typically beneficial to take the discounts.
Once you calculate your firm’s cash conversion cycle, it will indicate whether your customer collections practice needs attention and whether or not you’re maximizing the use of vendor terms. Reviewing your CCC trend line month over month can be a powerful tool to benchmark. By creating the most efficient cash conversion cycle, a pest control operator can start to see that the income on his or her P&L is real and not a fallacy.