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Preface: Goodwill is never a fixed rate calculation with an accredited appraisal. Goodwill calculations are more multidimensional than discussing with college professors how to assess individual student’s relative EQ during a lecture on 10 A.D. history.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value

Credit: Donald J. Sauder, CPA | CVA

Factor B is the business’s excess earnings that result in premium valuation from a rate of return on investment from the intangible assets cash flows of management decisions, employee activity, patents, processes, etc. Excess earnings are the net revenues above the ceiling of equity market rates of return on the tangible assets. For example, if a business produces substantial earnings above equity risk premium rate of return on tangible assets the business can appraise for a higher value, because it is a profitable investment grade asset. The key term is investment grade asset.

Economic and industry growth are also added to the goodwill equation with Factor C including the organizations ability to attract new customers and create more products, increase top-line sales volume, and strengthen cash flows. Of note is that recurring revenues  have higher goodwill multiples than transactional revenues, i.e. a bicycle shop has a different economic and industry growth characteristic than a farmer’s market stand, or a car wash.  Therefore the goodwill factors are for these reasons traditionally unique from industry to industry with an expert appraisal value.

Goodwill is never a fixed rate calculation with an accredited appraisal. Goodwill calculations are more multidimensional than discussing with college professors how to assess individual student’s relative EQ during a lecture on 10 A.D. history!

The Type of Goodwill Matters

Let’s look for a moment at the following picture of personal goodwill. Personal goodwill is from relationships developed between customers or suppliers and a business. The value that it adds for appraisal purposes is certainly controversial for many valuation analysts. One such legendary example of personal goodwill valuation is the Martin Ice Cream Co. v. Commissioner.

In Martin Ice Cream Co. v. Commissioner valuation negotiation with the Tax Court, the final ruling was that intangible assets encapsulated in the shareholder’s personal relationships with key suppliers and key customers were not assets of the shareholder’s corporation. Why? Because there was no corresponding employment contract or non-competition agreement between the selling shareholder and the corporate entity.  In this case, the shareholder, Arnold Strassberg, had developed personal relationships with his customers over a duration of approximately twenty plus years.  For the background, in 1974 the founder of Haagen-Dazs asked Mr. Strassberg to assist with his ice cream marketing expertise and relationships with supermarket owners and managers to introduce Haagen-Dazs ice cream products into supermarkets.

The tax court essentially ruled that the goodwill was not a corporate asset because while at the corporation, Mr. Strassberg was instrumental in the design of new ice cream packaging and marketing techniques; there were no legal contracts for his services on behalf of corporate operations.

This tax opinion, can reduce the value of a certain corporate stock appraisal because it is personal goodwill and not corporate goodwill, yet that value is still an asset. This area of tax law is best deferred to experts, because it is a double-edged sword in business appraisals depending on if you’re a buyer or a seller.

Preface: Anyone with a keen interest in history is familiar with the Tulip Mania in Holland. We can learn much from business history looking at enterprises during the Tulip Mania with regards to keeping business valuations in perspective for privately owned businesses today, and further elicit gems for consideration in accurate appraisal values from a proper perspective.

Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value

Credit: Donald J. Sauder, CPA | CVA

Introduction

As a process and set of procedures used to estimate the economic value of a (business) owner’s interest in an enterprise, business valuation is both an art and science. It is governed with models for financial market participants to determine the price(s) they are willing to pay or receive as a value to achieve a transaction of an enterprise at a set price. Yes, those financial market participants can be independent certified appraisers; and opinions are entitled to non-accredited business owners too.

Euphoric business valuations like euphoric investments, are as realistically permanent as the Dutch Tulip Mania. During the Dutch Golden Age the people of Netherlands had money up and down the social class. It was the richest country in Europe from the country’s great success in commerce and global trade. The aristocrats figuratively had money burning holes in their pockets, and so did the middle-class merchants, artisans, and tradesmen. With that extra cash, they had richer door man opportunities  to enjoy both leisure and investments.

At that time in the Netherlands, as has been for millennium, neighbors talked to neighbors, shopkeepers with candlestick makers, and dentists with booksellers. Tulip speculation was one such drawing conversation topic. Anyone with a keen interest in history is familiar with the rest of the story of the Tulip Mania in Holland. The point is that we can learn much from business history in Holland during the Tulip Mania with regards to keeping business valuations in perspective for privately owned businesses today, and further elicit gems for consideration in accurate appraisal values.

Few would counter argue this fact– we are in a business Golden Age. Since the long forgotten 2008 economic malaise, many entrepreneurs in management positions have minimal if any experience guiding an organization during monsoon conditions in the economic climate. Yes, it is the “Good old Days”.

Is the Question a matter of Goodwill?

Often, the most controversial feature of business valuation is goodwill. Many business owners have a realistic assessment of what their business assets are worth as tangibles, e.g., the computers, equipment and machinery you can see, but business goodwill is subjective. As the cherry on top of business value, goodwill is always a subjective value given to the intangible assets of a for-profit enterprise. Further, the true value is only verified with an exact balance at sale of a business interest.

Goodwill has multiple factors in a business appraisal. Let’s first look at Factor A: the going concern value of the goodwill. That is, the probability of the business continuing to produce net income effectively following the transferring of ownership in the capital of tangible assets , employees, and management.

This going concern factor assesses the appraisal value with the business continuing as a successful going concern after the transaction. The greater the probability of the going concern success feature in the business from systems , processes, location(s), name recognition, web reviews, customer loyalty, and transition guidance, the higher this component of goodwill.

Unfortunately, too many businesses have not invested in developing standard operating procedures or developing seamless transition plans years in advance to maximize this Factor. Their businesses are managed will less than optimal efficiency and hence resulting in reduced goodwill appraisals. Yet, the enterprises that have invested appropriately, should expect a premium valuation appraisal. An experienced valuator can assess this rather effectively and efficiently  from accurate cash flows, narrative, and analytical procedures.

End of Segment I

Preface: Did Nathan Jacobson thank his schoolmasters? We may never know. Math is good for school students, but it may be even more important in business success. If you’re an entrepreneur, consider writing a thank you note to your former math teacher today.

Math in the Workplace (Segment III)

Credit: Jacob Dietz, CPA

Price Increase Based on Percentage of Old Price

Now, let’s look at a price increase based on a percentage of the old price, with no change in cost. Last year, John’s cost of sales was 70%, his gross profit margin was 30%, his overhead was 15%, and his net income was 15%. He decided to increase prices because John’s advisor noticed that his income was below the benchmark for his specific industry. John’s advisor said he should be getting a 20% net profit in his industry, and he advised John to raise his prices 5% to increase his net profit from 15% to 20%.

The plan sounds good, but will it work? If John does the math, he will realize that the math does not work. If he raises prices by 5%, then a product that formerly sold for $100 will now sell for $105. That would change his cost of sales from 70% to 66.7% ($70/$105) and his net income from 15% to 19% ($20/$105.)

Why does it work that way? When calculating a net profit percentage, the net profit is divided by sales. Even though he would be making $20 on each sale, it would be $20/$105, which is 19%, not 20%. The increase in sales price therefore makes the additional $5 a smaller percentage of sales.

Price Decrease Based on Percentage of Old Price

Now, let’s assume that instead of raising prices, John decided to decrease prices because he is in a price-sensitive market and his prices are currently a little high. John’s cost of sales was 70% last year, and his gross profit margin was 30%, his overhead was 15%, and his net income was 15%.

John decreased his prices by 5%. Therefore, a $100 item’s price changed to $95, but the cost remained steady at $70 (now 73.7% cost of sales), overhead remained steady at $15 (now 15.8% overhead) and net profit dropped to $10 (10.5% net profit percentage.)

Therefore, the net profit dollars dropped by $5, but the net profit percentage dropped by only 4.5%.

Additional Takeaways from Pricing

If the prices are changing based off the old price, with no change in cost, then John may want to ask himself what he is trying to accomplish. If he is trying to reach a certain percentage, such as 20% net profit, then he may be disappointed if he only raises prices by 5%.

On the other hand, if he is trying to raise his net income from $15 to $20 for the unit that was selling for $100, then a 5% increase in price should do it.

Although the 5% drop in sales only led to an approximately 4.5% drop in net profit percentage, do not be deceived into thinking it was a small effect on net profit. At first, that may look like his profits only dropped by 4.5%. His net profit percentage decreased by 4.5%, but that is only his net income percentage. His actual profit dollars (assuming no change in volume) decreased by roughly 33% ($5/$15).

Why is there such a significant decrease in net profit dollars? If the sales price decreases, with no other changes, then that decrease in price drops straight to the bottom line.  His previous net income was $15, but now it is only $10. In some situations, however, the volume will change which can make up for the loss.

Math is more than a School Subject

If you are involved with pricing in your company, do the calculations when changing prices. Math is good for school students, but it may be even more important with a business. Consider writing a thank you note to your former math teacher.

This article is general in nature, and it does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

 

Preface: The inscribed square problem, also known as the square peg problem or the Toeplitz’ conjecture, is an unsolved question in geometry: Does every plane simple closed curve contain all four vertices of some square?  The problem was proposed by Otto Toeplitz in 1911. As of 2017, the general case remains open.

Math in the Workplace (Segment II)

Credit: Jacob Dietz, CPA

Pricing based on Costs When Costs Decrease

Assume the situation is the same as the above example, except John discovers that his cost of sales decreased by 5%. He decides to recalculate his prices.

He uses $66.50 as the cost, and he calculates a sales price of $95 ($66.50 divided by .7.) His sales price is $95, his cost of sales is $66.5 (70%), his gross profit is $28.5 (30%) and his overhead is $15 (15.8%) and his net profit is $13.5 (14.2%)

What just happened? Because John calculates his sales to earn a 30% gross profit, there was no change in the gross profit percentage, but there was a change in the gross profit dollars. 30% of $95 is $1.50 less than 30% of $100. John decreased both his gross profit and net profit by $1.50, and he dropped his net income percentage to about 14.2%.

Takeaways from Pricing

How can John use his knowledge about the effects on profitability of price changes and cost changes? If John’s costs increase, he may not be happy at first. If he can increase his prices using the same divisor (.7 in John’s case) on the new costs, however, John’s net profit can increase if he keeps selling the same quantity.

On the other hand, let’s assume that John faces fierce competition on price, and he cannot keep the same divisor of .7. In that case, he may be able to maintain the same net profit. For example, assume that his costs went up 5%, from $70 to $73.50. If John kept his normal divisor, he would then divide $73.5 by .7 and sell it for $105.  That would lead to the $16.50 profit instead of the $15 profit. If John could not raise the price $5, however, perhaps he could raise the price by $3.50 to $103.50. That would keep his net profit at $15. The calculation is the $103.50 sales price less $73.50 cost of sales less $15 overhead leaves a $15 profit.

At first glance, John may decide he makes enough profit at the $15 net profit even if he does not face withering competition on price.  He may decide only to raise the price to $103.50 instead of $105 because he will still come out the same at $15.

Or will he come out the same? Even though his net profit would still be the same, his cash position may not be the same. He is making the same net profit as before the cost increase, but his cost of sales jumped. If John carries significant inventory, then that additional cost of sales may hurt his cash balance. Each item that use to cost $70 now costs $3.50 more, or $73.50.

Preface: If you are involved with pricing in your company, do the calculations when changing prices. Math is good for school students, but it may be even more important with a business. 

Math in the Workplace (Segment I)

Credit: Jacob M. Dietz, CPA

Did you ever sit in a math class and ask your teacher “how will this help me in real life when I have a job?” Do you currently wonder how a change in price will affect your net profit or your net profit percentage? The math of a change in price can get complicated. This article explores price changes assuming the same volume of units will be sold. If the number of units sold changes, then it can get even more complicated. Hopefully this article will help demonstrate how math applies to real jobs.

Pricing based on Costs When Costs Increase

For this article, assume John runs a business and sets pricing. When preparing his price list, he realizes that his cost of materials jumped 5% from the year before. His overhead stayed the same. He decides to raise his prices 5% to keep his profits the same. That sounds simple. Is it really that simple?

First, let’s look at how the numbers worked for John’s business last year. Last year, his cost of sales was 70%, his gross profit margin was 30%, his overhead was 15%, and his net income was 15%. For every $100 that John sold, $70 went to cost of sales. Of the remaining $30 gross profit, $15 went to overhead and $15 went to the bank account as net profit.

John calculated his pricing based on costs last year. He took his cost of $70 and divided by .7 to calculate his sales price at $100.

Can John keep his calculations the same, but include the higher direct costs, and get the same profitability? John puts $73.50 into his calculation as the cost of sales (the $70 after the 5% increase.) John divides his cost of $73.50 by .7, and he calculates $105 as the new sales price. His price increased by 5%, which is the same percentage as his cost increased.

“What just happened? By using the same divisor (.7) to calculate his price based on cost when his cost of sales increased, John increased his gross profit, and kept his gross profit percentage the same.”

If John sells the product for $105, with the cost of sales at $73.50, his gross profit per sale is $31.50, or 30%. His net profit is $16.50 ($31.50 gross profit less $15 overhead), or 15.7%.

What just happened? By using the same divisor (.7) to calculate his price based on cost when his cost of sales increased, John increased his gross profit, kept his gross profit percentage the same, and increased both his net profit and net profit percentage.

Because John calculates his sales to earn a 30% gross profit (by dividing by .7) there was no change in the gross profit percentage. Since the sales price increased, however, John’s 30% gross profit percentage is now 30% of $105, not 30% of $100. That additional $5 in sales leads to a $1.50 increase in gross profit, which flows down to the bottom line as a $1.50 increase in net profit.

End of Segment I. To be continued.

 

Preface: Business investment value creation is a most opaque concept and process, even among experienced advisors. Yet, for the business owner with an investor business mind-set, it is of utmost importance.

Your Successor Looks at Your Business as an Investment

Credit: Donald J. Sauder CPA |CVA

Business transition advisors are necessary. Yet too often a majority of business owners omit realistic expectations on the investment feature of the transition.

If you think of your business as investment, and are interested in harvesting optimal value, beginning early with the following seven successful steps to the summit of business value creation can assist with a successful transition and an optimized fair market appraisal value to you as a business owner.

I. Adhere to a solid foundation of core values and a core focus (vision) for the business, identifying your business’s unique advantages, opportunities, and niche. Develop a one to three and ten-year plan. When your team strives every day to work purposefully per unified core values, and towards a common core focus, you can achieve great things, as the strong cultural bond of a shared purpose among your team drives the entire organization forward successfully.

II. Hire, train, and retain the best people as you build a talented team on the foundation from Step one. Without the right people, there is no success in business . Businesses thrive with expert, ambitious, talented, purpose driven teams. Your business’s ability to succeed in this area (the right people) is a key to your business’s future value. It is probable that this is where your next generation of transition ownership emerges, i.e., you develop it.

III. Continuously improve products and service solutions to meet the needs of your customers and clients both today and tomorrow, leveraging on the resources from Step two. Marketplaces shift and your business must adapt to successfully provide the best solutions for your customers and clients — they are the drivers of your business’s value from your business’s products and services delivered to them via your business team.

IV. Develop internal KPI’s and business operating systems that create and build value with performance efficiencies, and effective operations scalability. Your business needs to have processes to propel and govern operations and decision making, ranging from efficient and effective onboarding and development of employees to promptly invoicing and collecting on accounts receivable. Developed and implemented business operating systems successfully govern daily operations of the team. Again, this decreases cash flows risks and increases business appraisal value.

V. Further expand top-line sales volume, leveraging the implementation of Steps one, two and three. A great business is continually improving and growing. Successful businesses never stagnate entirely. Yet, growth can be managed with efficiencies and does not need to compound double digits’ sales  volume increases. It can include new technologies for improved product quality or systems for improved sales per employee, or even improved cash flow management. Again, the true value driver of your business (cash flow consistency) is often the core values that are ingrained in your team as they deliver to the marketplace with your products or services.

VI. Optimize an incredible sales experience for your customers and clients. The experience your customers and clients have transacting with your business is your foundational business reputation. Think of the business you purchase from. The experience of the entire sales process and your trust and appreciation of that service or product delivered (the sales experience) by the team living the core values of the business, and the business’s core focus is likely the prime reason you transact there. Optimization of the sales experience will reduce business risks, and improve cash flows. This combination propels business value higher.

VII. Persistent diligence to achieve and keep your business an industry leader. You must continually strive to keep a competitive edge in your marketplace. A lethargic environment is not an option. Strive tirelessly to leverage your business’s core, values and core focus and sales experience, along with expert, ambitious and purpose driven people that keep your business at the forefront in the industry with innovation. Then you will deliver successfully, day after day the best solutions to your marketplace in the most effective way possible.

Business investment value creation is a most opaque concept and process, even among experienced advisors. Yet, for the business owner with an investor business mind-set, it is of utmost importance. Your business is an investment to your successor, if it currently is not an investment to you. They will need to invest like you, with time, effort and resources to continue its success.  Applying the above “seven successful steps to the summit of business value creation” can help contribute to a successful transition to a successor from a financial perspective at an optimized fair market appraisal value for any business owner.

Conclusion of article.

 

Preface: When you appreciate that all the factors that result in a higher business value will also result in a higher probability of a the continued success of the next generation of ownership, you have now realized the fundamental purpose of why your business is an investment.

Your Successor Looks at Your Business as an Investment (Segment II)

Credit: Donald J. Sauder, CPA |CVA

Commonly, many business owners think about a business transition, and how they will accomplish the next generation succession, and even retain an advisor to begin work on transition, e.g., developing the succession plan. Yet, that is only one step of many in a successful transition. One possible counter argument may be that the value of the business is not really that important to the seller, and only a cohesive working relationship with the successor owner is desired as shares transfer, hence the need for an advisor. While that reality may be true, (and this article is written towards the financial context of business transition) so is the fact that a business may transition for many reasons, e.g., owner retiring, relocating, pursuing new opportunities or interests, or generally looking for reduced responsibility with the existing business venture.

The point is, all the factors that result in a higher business value, will also result in a higher probability of a successful next generation of ownership. This includes, a stable and motivated management team, operating systems that improve and sustain cash flows, realistic growth strategies, diversified business risks and minimized revenue concentrations, growing earnings, and effective debt or working capital management. Is your business an investment? Yes, it is.

Small business organizations supply ownership with the cash flow and net earnings to provide for current and future personal and family expenses, gifts to the community (it is not an oxymoron that the synagogues are credited) and thirdly for most small family businesses, it often is the key reason they are most often financially secure, e.g., the successful management and investment of time, talent, and resources that accumulate and compound with the years. Note: unreasonable transaction values do create substantial financial pressures for buyers if the business transacts at a price substantially above fair market value, and cash flows shift in the business. While fair market value is subject to debate, realistic fair market value is not.

If you do not want to be a statistical failure with business succession, here is one advisor’s words of advice. “Consistently adhere to strong bedrock values and work towards a clear and united vision as a team. That is the best way to sustain a healthy (business) organization.”

A Keystone Business Transitions, LLC article written from the desk of Donald Feldman titled: The 7 Deadly Transition Sins, outlines the following awareness of business transition risks: abbreviated,

1) Failure to have a solid buy-sell agreement for multi-owner businesses. Businesses without such an agreement are playing Russian roulette.

2) Failure to have a business Continuity Agreement for sole-owner businesses. If the sole owner dies or becomes disabled, the business is at risk of dissipation. A well-crafted Continuity Agreement might empower your key employees to run the business and give them compensation incentives to do it successfully.

3) Failure to choose among children to manage the company. Sometimes children can work cooperatively as business owners, but parents are generally poor judges of this and it is advisable to bring in an outside expert to assess the situation.

4) Reluctance to relinquish control. This problem is sometimes most acute in family businesses when mom and dad are reluctant to hand over control to the children. The longer this reluctance persists (men are much worse offenders than women here), the more difficult the transition will be. As a rule, ownership transfers should begin no later than age 65.

5) Failure to think clearly about the tax consequences of ownership and management.

6) Failure to sell at the right time. Owning a business is an inherently risky enterprise. If you are at an age when you cannot afford to wait out a prolonged slump, you should sell while the market is good. The strong M&A market we have enjoyed for the last several years won’t last forever.

7)Failure to transfer ownership to the next management generation.

End of Segment II. To be continued.

Preface: When a business transition occurs, approximately forty-five percent of  owners will sell to a key employee or family member, and fifty percent will sell to an outsider; and roughly five percent of the businesses will not sell or transact at all….here’s what you need know for your future transition.

Your Successor Looks at Your Business as an Investment

Credit: Donald J. Sauder, CPA |CVA

Small business organizations in the United States contain both future opportunities and risks for enterprising talent and business owners alike. First, seventy-five percent of these small business organizations have a majority owner that is fifty years of age, or older. For most business owners in this majority it represents a business risk that statistically says fifty to seventy-five percent of the owner’s retirement net worth is in their business valuation  or the fair market transaction value of the business. Yes, most of these business owners factually have only ten to twenty-five percent of their net worth in investment assets outside the business e.g., an investment portfolio or 401k plan. Therefore, in many cases, harvesting that business value is crucial to the small business owner and their family’s financial future. Business value is much like an agricultural crop of wheat or corn, a successful harvest is not guaranteed but always anticipated.

“One of the common, substantial, and problematic factors in harvesting business value is the expectation of that business’s fair market transaction value to a buyer i.e., the appraisal.”

When a business transition occurs, approximately forty-five percent of these owners will sell to a key employee or family member, and fifty percent will sell to an outsider; and roughly five percent of the businesses will not sell or transact at all. Of those businesses , fifty percent plan to transition shares within three years and seventy-five percent plan to transition in ten years.

Beyond statistics, if you are one of these small business owners in the majority, preparing and planning your business transition is certainly advised and necessary. One of the common, substantial, and problematic factors in harvesting business value is the expectation of that business’s fair market transaction value to a buyer i.e., the appraisal. While this variable changes from year to year based upon net earnings, cash flows and EBITDA, customer concentrations, revenue propellers, and other factors relevant to the future probabilities of discretionary earnings in the business, tracking and benchmarking that value helps set proper transition expectations.

Setting appropriate expectations early is a keystone of successful ownership transition. Strategic business owners will value  their business at least twice before beginning a transition of ownership. This helps benchmark value expectations and sets a realistic foundation to optimize appraisal values for a future transition of business ownership.

“Too often, for most business owners, they approach business valuation as a second step in the transition process.”

There are multiple business valuation metrics, approaches and variables in appraising an accurate and fair market business value. For instance, the Asset approach will arrive at an entirely different value than say, an Income approach or Market approach, and a Market approach is subject to likewise variables in comparisons of product, market depth, and business locale. A realistic business valuation will include at least two comparisons of value in the report, e.g., an Income and Market approach.

Business valuation is more than financial analysis; it is an art and a science that requires appropriate expertise to obtain accurate fair market transaction appraisal value. It is at the capstone, a prophecy on  the future cash flows of the business, discounted to a current value.

Too often, for most business owners, they approach business valuation as a second step in the transition process. It’s alike to savoring a large ice cream cone on very warm summer evening, i.e. they forfeit the opportunity to maximize appreciation [value] on the sale of the business (the investment) with proper planning and performance improvements that can sometimes substantially increase harvest yields, i.e., the business value.

End of Segment I. To Be continued.

Preface: What is the benefit of all this management of accounts receivable and inventory and accounts payable, i.e. the cash conversion cycle components? Naming only two characteristics: 1) improved liquidity, and 2) more efficient use of working capital.

Cash Conversion Cycles (Segment II of II)

By Jacob M. Dietz, CPA

Inventory

Mapleberrytown looked at some industry standards that their accountant gave them for inventory days, and they realized that the industry is at 100 days. They reviewed their historical inventory days, and they realized that 1 year ago they were at 127, two years ago 115, and 3 years ago at 110. They are currently at 130 inventory days.

What can they do? Inventory management is a huge topic. The specifics of inventory management go well beyond the scope of this blog, but they could begin to look for low-hanging fruit. For example, are they overstocking inventory? If inventory is being stocked at too high levels, it ties up cash.

Mapleberrytown realized that they were stocking too much Widget Component B. Their lead time to get it is 2 weeks, but they have a 2-month supply on hand. When the person responsible for ordering was questioned about it, he responded that he is petrified of running out of the product. After sitting down and discussing the needs for that component, however, they developed a plan to have an appropriate stock level without tying up too much cash.

If inventory is a major component of your business, consider taking the time and really learning about inventory management. If inventory management can be improved, it can make a significant difference on the bottom line.

If a company drags out accounts payable too long, however, then vendors may stop selling to the company, or make them pay on delivery. There are also ethical concerns about waiting too long to pay vendors.

Accounts Payable

Last, Mapleberrytown examined their accounts payable practices. accounts payable days are subtracted when calculating the cash conversion cycle because it is a delay in paying cash. From a cash point of view, longer is better.

If a company drags out accounts payable too long, however, then vendors may stop selling to the company, or make them pay on delivery. There are also ethical concerns about waiting too long to pay vendors.

Mapleberrytown compared their accounts payable balances to previous years, and they discovered that the accounts payable days were steadily getting shorter. Next, they realized that their accounts payable days were below the industry standard. They are paying their bills faster than they did in the past, and they are paying faster than their competitors.

Mapleberrytown decided to go ahead and keep paying so quickly. One factor in the decision was that some of their vendors give them a 2% discount if they pay in 10 days.

Benefits of Shortening the Cash Conversion Cycle

What is the benefit of all this management of accounts receivable and inventory and accounts payable? One benefit can be less cash tied up in the business operations. If less cash is tied up in the business operations, then the business may be able to operate without a line of credit, or with a smaller balance on the line of credit. If the business has no line of credit and funds its operations with cash, then more efficient operations may allow the business to have more money in the bank to fund operations if times get rough. Furthermore, if a business is profitable and uses good cash management, some of that cash may be available to invest in business growth.

How healthy is your cash conversion cycle? Do you have money locked away that you wish you could access?

This article is general in nature, and it does not contain legal advice. Please contact your accountant to see what applies in your specific situation.

 

 

Preface: Managing cash flows adroitly is an important task to every business owner. Continuing reading to learn how the cash conversion cycle works, and what you should be aware of to optimize its role in monthly and quarterly cash flows. 

Cash Conversion Cycles

By Jacob M. Dietz, CPA

Imagine if you had $5,000 in cash, and you locked it in your safe. Unfortunately, you dropped the key into the bottom of a river while walking across a bridge. You call the safe company, and they agree to come and unlock your safe for you – in 15 days. That $5,000 is legally yours, and it is sitting right in front of you. You have every legal right to it, but it does you no good without a key. Understanding cash flow and taking steps to improve it can be a key to unlock cash flow.

Specifically, the Cash Conversion Cycle measures the days your cash is tied up in accounts receivable, the days it is tied up in inventory, and then subtracts the amount of time you save by using accounts payable.

Cash Conversion Cycle

The Cash Conversion Cycle is a measure of how many days your cash is tied up in a noncash form during your business cycle. Specifically, the Cash Conversion Cycle measures the days your cash is tied up in accounts receivable, the days it is tied up in inventory, and then subtracts the amount of time you save by using accounts payable. The specific calculations are beyond the scope of this article, but in general accounts receivable days are a measure of how many days it takes to collect your accounts receivable, inventory days is a measure of how long your inventory is around, and accounts payable days is a measure of how long it takes to pay your accounts payable.

Cash Conversion Cycle = Accounts Receivable Days + Inventory Days – Accounts Payable Days.

Suppose Mapleberrytown Widget Mfg, LLC is a manufacturing company that buys in widget components, manufactures widgets, and then sells the widgets to distributors. When they begin looking at their Cash Conversion Cycle, it is 150 days. Their accounts receivable days are 35, their inventory days are 130, and their accounts payable days are 15.

150 days = 35 accounts receivable days + 130 inventory days – 15 accounts payable days.

Accounts Receivable

First, let’s look at accounts receivable. Is 35 days good or bad? Compare the number your business’ historical trends and to the industry. In this case, Mapleberrytown Widget’s industry standard is 30 days. Their historical trends reveal that 1 year ago their accounts receivable days were 33, and 2 years ago their accounts receivable days were 32.

Both the industry comparison and the historical comparison indicate a problem. What can they do? In Mapleberrytown’ s specific situation, they realize that they some customers are paying in 50 or 60 days, even though the invoices are supposed to be paid in 30 days. Upon closer inspection of the invoices, Mapleberrytown realizes that they do not indicate a timeframe to pay them. They immediately started printing a note on the invoices indicating that they are due in 30 days. Mapleberrytown decided to send out statements every month to late customers asking for payment.

Conclusion of Segment I.