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MANAGEMENT: How fast can a company convert cash into even more cash?
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How fast can a company convert cash into even more cash?

By Marwan Emile Faddoul

BT 201504 12 Management 1By aiming to reach rapid growth, a Chinese manufacturing company committed a huge mistake that almost made it go bankrupt. Nevertheless it was able to make it up and turned itself from being one of the smallest companies in the field to being a major contender. What went wrong, and how was it able to get back on its feet?

To illustrate this issue, I will share with you the story of a hypothetical Chinese friend, whom we will call Mr. Zhang, who is running a hardware manufacturing store. His company was established in 2009 and was specialized in producing different types of smart phones and tablet pcs.

The company's main strategy was to sell directly to customers. It combined its low cost sales and distribution model with a production cycle that began after the company received a customer's order. This made to order (MTO) model and manufacturing process empowered the company to deliver a customized order within two to three days, and yielded low finished goods inventory balances. Unlike its competitors, who built to forecast and maintained sizeable finished goods inventory in their stock or at their channel partners, my friend's company maintained only hardware components in its warehouse. These components ranged from processors, Graphics, memory to batteries and cameras, were based on sales forecasts and were sourced mostly from local suppliers.

Little by little my friend was able to expand and make a name for himself, yet he was far too small than his giant competitors. He knew he had two choices in front of him: either to stay small and face the consequence of being crushed by his competitors within months, or to go for big time growth in one big jump.

BT 201504 10 Management HLHis mind was set, and on March 2011, Mr. Zhang went aggressive in the market, investing millions in marketing campaigns, in an attempt to capture sales from small businesses and first time consumers. Over the next two years, the company enlarged this indirect distribution channel by adding other mass market retailers and by expending to foreign markets, relying on resellers to distribute the company's products. Mr. Zhang's strategy seemed to work, and his sales increased by more than 150 percent within less than two years. But without knowing he was losing money.

On September 2013, the company reported about 5 million CNY loss for the second quarter of that year. The loss was tied to 4 million CNY in charges relating to the sell-off of excess inventory. Like many companies, Mr. Zhang's manufacture was focused on its Profit &Loss statement, but cash flow was not a regularly discussed topic. It was as if he was driving along watching only the speedometer, when in fact it was running out of gas.

Later that year I met with Mr. Zhang, and discussed ways to solve the company's problems and to put it back on track. After several weeks of preparation and planning, we decided to shift the company's focus from exclusively growth to liquidity, profitability and growth. It adopted company-wide metrics around the new focus. In addition, the company took measures to improve its internal systems for forecasting, reporting and inventory control. Furthermore, a new vendor certification program was put in place, reducing the number of suppliers, ensuring component quality, and improving delivery performance. Finally, the company decided to get rid of all its retailers, and returning to a straight to the customer model. This was done through a massive expansion in internet distribution.

These changes fueled the company's recovery, yet it was down to two essential criteria that the company instituted its goals on: The ROIC (Return on Invested Capital) and the CCC (Cash Conversion Cycle).

Why did I ask my friend to focus on these two elements and how did it help?

For the case Mr. Zhang had, just like most of the manufacture companies, it is important to know where to invest the company's money and how the cash cycle is being monitored.

BT 201504 13 Management 3he return on invested capital helps to determent the company's financial performance and is used to measure how well the company is investing its capital. On the other hand the cash conversion cycle is a metric that expresses the length of time, in days, that it takes for a company to convert resource inputs into cash flows. The cash conversion cycle attempts to measure the amount of time each input dollar is tied up in the production and sales process before it is converted into cash through sales to customers. This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties.

By presenting a well-developed and precise financial statement that includes the income statement, the balance sheet and the cash flow statement, the company was able to implement the ROIC and CCC formula, and eventually identify the weaknesses in their cash cycle.

On November 2014, almost fourteen months after identifying the initial problem the company's losses, Mr. Zhang's Company had managed to reduce its days of inventory outstanding by 56%, lower its Account Receivable to 68% in comparison to its previous year, and increased its days of payable outspending by 31%. As a result, he was able to reach a negative cash cycle where he was able not to pay for his inventory until after he had sold the final product associated with them. He was simply able to convert cash in hand into even more cash in hand, within a very short period of time.


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