Like ocean currents, cash flow is defined by its direction and its velocity. Its flow may be in a beneficial direction, helping to push you towards where you want to go, such as when flowing in from a customer paying your invoice. Cash also flows in a less favorable direction, working against you, such as when it flows out to pay a vendor for inventory sitting on your shelf, or for labor invested into work-in-process. The flow rate or velocity accentuates both the favorable and the unfavorable direction.
Cash Velocity is the metric, stated in the number of days, of how quickly the cash used to pay for obtaining or producing a discrete unit of your product or service (and hopefully a little more) is collected from your customer for that discrete unit of your product or service. So Cash Velocity is related to a complete cash-out-to-cash-in flow cycle by the dimension of time.
We discussed the importance of cash flow in an earlier post, so let’s look at the advantages of tracking Cash Velocity:
- The faster you get money flowing into your company, the faster it is available as working capital. You can use cash velocity information to more accurately project working capital requirements for various activities, such as financing raw materials or inventory.
- By knowing where and for how long your working capital will be tied up, you can spot potential cash shortages earlier and act to reduce their impact.
- You can identify cash surpluses, which can be invested for additional earnings.
- Examining the cash velocity generated by each customer, product line or business activity greatly enhances your ability to understand the true value of each.
- You can use your cash velocity metric to make your budgets more accurate and more reflective of your business.
What is a complete cash-to-cash flow cycle? Using the manufacturing process as an example, the cash-to-cash cycle begins when you pay for the raw materials needed to produce a discrete unit of your finished goods. The cycle continues through the time required to covert the material into a product, warehouse it, package it, and deliver it to a customer. Invoicing your customer begins the last step of the cash-to-cash cycle, which completes when you receive full payment on your invoice for that particular unit.
Your goals are to increase the amount of cash that you generate—that flows in—usually by increasing your sales volume and lowering your costs, and to reduce or eliminate the time between when you pay your vendors and collect from your customers for each discrete sales unit.
Continuing our manufacturing process example, there are several ways to shorten the cycle time on the cash out-flow end: stock less raw material, convert the raw material into finished goods more quickly or institute just-in-time processing. You can also negotiate extended payments terms with your vendors.
On the cash in-flow end, you could shorten the cycle time by negotiating for payment in advance or selling for cash. You can also bill faster, offer a prompt payment discount and accelerate accounts receivable collection.
Of course, your customers and vendors are also trying to hang on to their cash longer and collect from their customers sooner.
A very high cash velocity can be an indication that you have a credit policy that is too tight and is constraining your sales. Also, if you are in a cash crunch situation, your cash velocity may be more important than the volume of cash you generate or even the profit. And lastly, though the cash velocity metric is a useful snapshot, it is often the trend that is more important. If the number is trending up, immediate action is often required. But these are topics for another day.
For our discussion on why your priority should be cash flow first, then profit, you can go here .
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