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Cash to Cash Cycle

Lean views a business as a stream of value-adding activities that culminate in satisfying

a customers' real needs. Key agents propel this stream. First and foremost of these are
people. Their decisions and actions are the fundamental drivers of the value stream.
Another is operating equipment. Some equipment transforms materials into the finished
offering the business delivers to its customers. Other equipment transfers the offerings
to the customer. A third factor that propels the value stream is cash. Yes, cash is a
factor that fuels value stream activity. It is used to acquire and support activity by the
other factors of production and, in that sense, shares in enabling their productivity. Like
any of these factors, its availability for service constrains its utility—i.e., when it is not
available, it cannot be adding value and therefore is simply waste. Use the concept of
machine uptime as an analog for cash availability. If a machine is up, it can be put to
productive use. If it is down for maintenance or repair—it is non-productive and thereby
waste. When cash sits locked up and out of reach such that it cannot be invested in
activities that propel the value stream, it too is non-productive and therefore waste.

How do you measure whether you are operating "lean" with regard to cash? And, how
does implementing lean improvements free cash to be value adding?

The Cash-to-Cash Cycle

One way to detect how lean you are operating with regard to operating capital—the
funds available for use in financing the day-to-day activities of a business—is to
measure the length of the cash-to-cash cycle. The cash-to-cash cycle1 calculates the
time operating capital (cash) is out of reach for use by your business. The speedier your
cash-to-cash cycle, the fewer days your cash is unavailable for use in propelling your
value stream. You can use this metric to gauge whether you are operating "lean" with
regard to cash. Also, good performance on the cash-to-cash measurement has been
associated with improved earnings per share (Ward, 20042).

When is Cash Out of Reach?

Your business's cash is out of reach when it is uncollected from customers and when it
is soaked up by inventory that sits on the shop floor, in office storage areas, or on
computer disks.
Uncollected payments are termed "receivables" and are reported on your business's
balance sheet. How quickly a receivable is registered and how long it sits uncollected is
determined by your business's order-to-cash-receipt value stream.

Inventory is cash converted into materials and intermediate outputs that are not ready to
benefit a customer. Think of inventory as a cash absorbing sponge. As long as
inventory sits, it holds your cash captive. How long it sits is a function of how well your
supply chain and production value streams are synchronized with customer demand.
When these systems flow, are pulled by the customer, and free of all waste—inventory
is zero.

Cash to Cash and the Extended Value Stream

A neat feature of the cash-to-cash cycle is its ability to represent how efficiently the
extended value stream is operating (Exhibit 1, below). As you know, for an enterprise to
be truly lean, it must apply lean thinking to improving the operations of both its suppliers
and its customers as well as itself.3 For the flow of cash to be optimized,4 you need
alignment and synergy across the extended value stream.

How to Compute the Cash-to-Cash Cycle

The cash-to-cash cycle is computed using the number of days that cash is invested in
inventory plus the days that your uncollected earnings sit as receivables less the days
cash remains available to your business because your business has yet to pay its bills
(e.g., for goods or services from its suppliers). This last element may seem odd since
one typically thinks of debts as money spent and gone. But, in business, just as in our
personal lives, the longer a debt goes unpaid, the longer that cash remains with the
business (or us) and therefore available for use. This reverse benefit from not paying
debts does create an opportunity to improve your cash-to-cash cycle in ways that are
inconsistent with the lean model—and we will discuss this below. For now, it should
seem clear that the faster your business turns over its inventory, the faster it bills and
collects what is owed to it, and the slower it pays its debts—the better its operating cash
position. Exhibit 2 presents how to compute the cash-to-cash cycle time.

Exhibit 2. How the Cash-to-Cash Cycle Is

Computed for a Given Reporting Period
Cash-to-Cash Cycle =
+ Days Cash is Locked-Up as Inventory
+ Days Cash is Locked-Up in Receivables
- Days Cash Is Free Because the Business
Has Not Paid Its Bills

Think about this formula for a moment and it should make sense. The days a business's
cash sits locked-up as inventory, it is unavailable. Since these days extend the cash-to-
cash period, add them. The more days the cash a business earns through sales is
uncollected, the longer the cash remains unapplied to adding value, so we add these
days as well. On the other hand, the longer the business holds on to its cash by not
paying a debt it owes, the more cash it has to propel its value stream. We therefore
deduct these days from the cycle to reflect that cash is available. Again, this last
element has a funny ring to it because it suggests that it is to a business's benefit to
drag its feet in paying what it owes or pressure vendors to accept longer and longer
repayment period. And, as you can see from the formula, it will make the business look
better on this metric.5 But, put that concern aside. For now, see how this metric works.
Exhibit 3 presents how to calculate each component that contributes to the cash-to-cash
cycle time.

Exhibit 3. Components of the Formula Used to

Compute the Cash-to-Cash Cycle
Component How to Calculate It
Inventory Average (Cost of
Days Cash is Dollar Value Goods
Locked-Up as Inventory Sold)* /
Inventory During the Number of
Reporting Days in the
Period Reporting
Period)
Receivables Average (Sales /
Days Cash is Dollar Value Number of
Locked-Up in of Accounts Days in the
Receivables Receivable Reporting
 During the Period)
Reporting
Period
Unpaid Bills Average (Cost of
Days Cash Is Dollar Value Goods Sold
Free Because of Accounts / Number of
the Business Payable Days in the
Has Not Paid During the Reporting
Its Bills Reporting Period)
Period

*Obtain the Cost of Goods Sold (COGS)6) for the reporting

period from the business's Profit/Loss statement for that
period. If it is not available, compute the cost of goods sold
(COGS) using the following formula: COGS = Dollar Value of
Inventory at the Beginning of the Reporting Period + Dollar
Value of Purchases During the Reporting Period - Dollar Value
of Inventory at the End of the Reporting Period. "Purchases"
refers to materials and supplies bought for producing new
outputs.

Example

Exhibit 4 presents excerpts from the XYZ Business's Balance Sheet and Profit/Loss
statement for January 2006. All dollars are reported in units of a million.

Exhibit 4. Excerpts From XYZ's

Financial Statements
Information Jan 1 Jan 31
Balance Sheet
Accounts Receivables $400 $600
Raw & Finished Goods $500 $300
Inventory
Accounts Payable -$300 -$100

Profit/Loss Statement
Sales $1,000
Cost of Goods Sold -$ 700
Gross Margins $ 300
Using the information in Exhibit 4, we can compute XYZ'z cash-to-cash cycle time for
January (Exhibit 5).

Exhibit 5. XYZ's Cash-to-Cash Cycle for the Period January 1

Through January 31
Component Computation Result
Inventory - Average number = ($500 + $300 / 2) / = 17.70
of days ($700 / 31 days)
Receivables - Average = ($400 + $600 / 2) / = 15.50
number of days uncollected ($1,000 / 31 days)
Days Cash Is Free Because = (-$300 + -100 / 2) / = -8.80
the Business Has Not Paid Its ($700 / 31 days)
Bills
Cash-to-Cash Cycle 24.40
(in days)

Based on this information, XYZ had its operating capital locked-up for 24.4 days before
it became available. The performance is less speedy when the effects of holding
payments to vendors is extracted (33.2 days).

Desired Results of Cash-to-Cash Cycle

In a truly Lean system, there is no waste in any value stream. Goods are not
manufactured or shipped to the customer unless “pulled” and they are produced by
production systems that flow continuously without reliance on inventory. Raw materials
are not acquired and processed unless a customer demands a finished output.
Customers are billed and pay immediately upon receipt of a purchased product or
service. In its ideal state, it is a just-in-time system from the origins of its supply chain
through to the receipt and payment by its customer. In this scenario, the lean producer
also pays its suppliers upon receipt as its customers pay upon delivery. There are zero
receivables, inventory, and payables and thus a zero day cash-to-cash cycle time.
Although a zero-day cash-to-cash cycle is truly Lean, your business approaches its best
achievable state progressively by shortening the cycle times it initially displays.

Interpreting Cash-to-Cash Cycle

While a shorter cash-to-cash cycle is generally considered a positive indicator of
operating leaner, you need to look deeper to be sure. You can achieve shorter or even
negative cycle times by means that are inconsistent with lean. As stated previously, you
can shorten your cycle times by pressuring your vendors to accept delayed payments
for goods they deliver.7With regard to longer cycles, some industries have inherently
longer lead times for accomplishing their value streams than other industries. If you
build large complex outputs like warships or office towers for example, your business's
cash will be tied up longer than say for a business that is a computer systems
integrator, like a Dell or Gateway, where they assemble their products in minutes.

To properly evaluate your cash-to-cash cycle performance, you need to analyze your
cycle time in conjunction with other information. First, always assess it over time. The
trend of your cycle time is more critical than its value at a single point. Second, if you
want to understand a point-in-time value, look to the typical cash-to-cash cycle for other
businesses in your industry.6 You always want to have faster conversion cycles than
your competitors. Third, before celebrating any apparent achievement in cash-to-cash
speed, make certain that you read and apply the cautions described below. Each
explains a way you can achieve fast cash turnaround that we would not perceive as
worthy or smart from a lean perspective.

Cautions

1. Squeezing suppliers – Some companies shorten their cash-to-cash cycle and can
achieve negative cycle times by squeezing their suppliers to accept long payment
periods. This is possible for companies that have size and great buying power relative
to the vendors whose products or services they purchase. The buyer uses its power
to control its suppliers behavior. From a lean perspective, such control strategies
corrupt the extended value stream by pitting components against each other. On a
purely pragmatic level, such squeezing can undermine the viability of your suppliers
and do undermine your supply relationships. Threatened and exploited suppliers are
provoked to develop a counterbalancing force to offset your buying power. They will
seek to dilute that power through commercial or political action that progressively
erupts into full blown adversarial relationships.
Failsafe: A simple check is to obtain the computed value for the "Days Cash Is Free
Because the Business Has Not Paid Its Bills." In the example presented in Exhibit 4,
above, the number is negative. The ideal value from a lean perspective is actually
zero (0). You can also request from accounting an aged payables report. This report
will show you the distribution of payables by various time periods—e.g., 30 days, 31
to 45 days, 46 to 60 days, over 60 days. Almost all payables should be under 45 days
in age. If you note that 10% or more of the payables are unpaid for longer than 45
days, then consider yourself as using your vendor's cash to augment your operating
capital.
2. Verify Turnover Success Is Due to Lean Improvements - Before celebrating a
reduction in your cash-to-cash cycle time due to reduced days of inventory, make
sure your inventory success results from being truly lean. Use the guidance in the
article Inventory Turnover to make this judgment. You need to analyze your
improvement with inventory in conjunction with other trends within your financial
statements to ensure that your operations are truly business beneficial. For example,
you can get apparent improvements in inventory management by advanced sales,
phantom sales, or discount-driven sales. Advance sales cause a point-in-time
improvement that reverses in the very next reporting period. The other two methods
actually harm your business. Also, you can produce improved inventory results by
applying control strategies that force customers to take finished products before they
need them.
Failsafe: Use the guidance in the section Interpreting Inventory Turnover, to verify
that your success with reducing the days of inventory your business maintains is due
to the effective application of lean thinking.

How to Improve Cash-to-Cash Cycle

To improve your cash-to-cash cycle, begin internally. Start by reducing your inventory
and increasing inventory turnover. This will speed the cash-to-cash cycle. In parallel,
Kaizen your order-to-cash-receipt work processes. Speed the invoicing process, reduce
billing errors, speed response to overdue bills, and reduce the incidence of bad debts.
As your cycle time and error rates come down, cash becomes available to enable timely
payment of your suppliers and redeployment in your business. Next, develop a supply
chain that reliably provides you exactly what you need, just when you need it, with the
least waste incurred on the part of your suppliers and your business. This will minimize
both inventory and the cash you need to spend for the inputs you require.

Remember, as you pursue perfection, be certain to implement improvements that

benefit all members of the extended value stream. Lean requires inclusive thinking so
that optimization of one component does not create waste or diminish value in another
component.