3 minute read / Aug 15, 2017 /
Why Cash Conversion Cycle Matters for Your Startup
The cash conversion cycle is a key metric for startups, but one that often isn’t talked about until a business hires a CFO. Once a business established product market fit, the cash conversion cycle is a key metric of a company’s cash efficiency - how quickly a company can convert a dollar of investment into a dollar of cash flow.
To calculate the cash conversion cycle for a software company, the formula is
`CCC = Sales cycle + Accounts Receivable Latency - Accounts Payable Latency
Sales cycle is the number of days from first engaging a customer to when the customer signs a contract. Accounts receivable latency is the amount of time from the contract being signed to the customer paying for the service. Accounts payable is the number of days from when the business receives its bills and when it pays them. That’s all a bit amorphous so let’s compare two hypothetical situations.
In the case of the Short Cycle, the CCC is 45 days compared to 330 for the Long Cycle. Why is this so important to a business? For the same reasons payback periods are critical. The faster an invested dollar is recouped, the sooner the business can invest it again in lead generation, sales development and account executives.
In the Short Cycle, the business can buy $1 worth of leads every 45 days. In the Long Cycle, the business must wait nearly one year before investing that dollar. Either the Long Cycle company must raise much more capital, and be diluted further, or it will grow more slowly.
Of the three parts of the cash conversion cycle, only one component is determined by the go to market organization: the sales cycle. The other two parts, accounts payable and accounts receivable, are the responsibilities of the finance teams.
By collecting payments from customers promptly, the finance team improves the CCC of the business. More cash to invest in growth sooner. And by negotiating for better payment terms, a longer time to pay bills, the finance team keeps more dollars in the company’s accounts to invest. For example, if the Short Cycle startup can negotiate 90 day payment terms and their CCC is 45 days, they could theoretically invest a dollar twice in growth before paying it to a supplier.
The paragraph above illustrates why CCC is a metric most startups begin to measure after hiring a CFO. The finance team is a critical part of managing CCC. But the sooner the business can understand, measure and tune its CCC, the more sooner the business can reinvest dollars to grow faster.