A Math Word Problem for CEOs
I hated math word problems as a kid, so I’ll make this a pain-free version with an easy question!
I recently wrote about CEOs’ need for a high understanding of their financial situation and wanted to follow up with an illustrative story. I specifically mentioned that, as a CEO, you should understand your cash conversion cycle. Let’s call it your business model. How does the cash flow through your business?
This may sound esoteric, but optimizing cash flow in your business is just as important as optimizing blood flow through your veins. Blockages and slowing will kill you or your business.
These two examples illustrate both bad and good blood flow (I worked with both of these companies):
Company A produced their product in China and paid for it by letter of credit before it left the port in Hong Kong and was shipped via cargo ship (i.e., they paid for the components long before they could sell them). It was then delivered from the port via train and truck to a centralized warehouse. Some light assembly was required. Many of the products were “replenishment” items, so the company carried inventory in the warehouse to fill the orders that they expected. The products were sold to retail companies, and the terms were net 30. Because the retailers had most of the power, they paid in 75 days. Some retailers demanded markdowns for slow-moving items and returned items that didn’t sell quickly.
Here’s the measure of cash flow for company A. From the time they paid their manufacturing company in China until they collected the funds from their customers, 111 days had passed. If there was a big sales bump, they had to borrow a large amount of money from the bank to fund the purchase of goods, which added interest expense. If there were hiccups in the sales process (at retail), they were in trouble. It was cash-intensive for this company to grow; their cash conversion cycle was very long.
Company B had little inventory or finished goods. Eighty percent of the business was cash, so they had little accounts receivable. The production equipment was leased, and they often negotiated for it to be delivered several months before making a lease payment. Payroll (the largest expense) was every two weeks and, of course, in arrears. The cash conversion cycle was a negative 30 days — they got paid from their customers 30 days before their bills were due. They could grow without borrowing money, and the faster they grew, the more cash they produced.
The return on invested capital (a solid way to view company performance) in company B was huge and in company A was marginal. Which business would you rather invest in?
Business models aren’t formed in cement. With work, you can change them. Even a few more days of cash in your business (i.e., turning product into cash faster) can have dramatic impact.
I offer this as a tangible illustration of how thinking about your business at a cellular level can have great positive impact. Consider taking a deep dive into your financial statements to see what you can find!
coaches CEOs to higher levels of success. He is a former CEO and has led teams as large as 7,000 people. Todd is the author of, Never Kick a Cow Chip On A Hot Day: Real Lessons for Real CEOs and Those Who Want To Be (Morgan James Publishing).
Connect with Todd on LinkedIn, Twitter, call 303-527-0417 or email [email protected].