Less Cash Out is as Good as Getting it Back FasterCommercial construction is a chronically cash-crunched business. Long operating cycles make cash management an important part of running a commercial construction firm. This article explores how to measure the Cash Conversion Cycle (the time it takes a firm to turn cash on hand into additional cash on hand through operating cycle) and introduces options for managing this cycle for an improved cash position and increased profits.
Cash is the lifeblood of a company. It keeps the lights on and keeps material flowing so that the firm can pursue profit-generating projects. The Cash Conversion Cycle, or CCC, is a useful metric for measuring and managing cash flow. In this article we will describe how shortening the CCC leads to an improved cash position and increases opportunities to pursue profit-generating projects. We will also show how to break the CCC down into three sub-components and discuss the options for managing each. We will show how two components, Days Inventory Held (DIH), ans Days Sales Outstanding (DSO) hold the most potential for increasing the profit-earning power of commercial construction firms.
The Cash Conversion Cycle, or CCC, is one of the most useful “dashboard” metrics for cash management. The CCC measures the time it takes for a dollar spent on material to return as cash received from clients (i.e. the time, in days, from actual cash leaving the company until it returns, as cash, to the company). The CCC can further be broken down into three sub-components, each of which can be managed to varying degrees. Let's start by looking at the CCC as a whole and then dive into the three components. The standard CCC is given as:
CCC = Days Inventory Held (DIH) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO), or
CCC = DIH + DSO – DPO, where
DIH = Inventory/(COGS/365),
DSO = (Accounts Receivable)/(Sales/365), and
DPO = (Accounts Payable)/(COGS/365).
Visually, the CCC is:
Image source: https://seekingalpha.com/article/4100718-teslas-unusual-source-cash
Why measure the CCC?
Measuring the CCC is useful for managing the short- and long-term financial health of a firm. In the short-term, measuring the CCC helps insure that there is enough cash on hand to cover day-to-day expenses. For example, if you know your firm's CCC is 120 days, then you can prepare a cash budget that funds 120 days worth of investment in each project. For most firms, that means arranging for 120 days worth of financing before the project gets underway. Waiting until after a project is underway to fund the project's cash flow needs often leads to cash shortages and disputes with subcontractors and vendors who are waiting for payment.
In general, a shorter CCC is better. A shorter CCC means cash returns to the firm faster. This reduces financing costs for firms that borrow to fund the CCC, increases cash on hand in a given period, and allows the firm to take advantage of investment opportunities (e.g. bid new jobs) that they would otherwise have to forgo because there is not enough cash on hand to start work. Being able to take advantage of additional profit-earning jobs increases the lifetime profit earned by the firm.
In the long-term, the CCC is a determinant of firm value, where firm value is defined as the present value of the sum of all expected future free cash flows. With a positive CCC, cash is invested in the operating cycle for some time before it returns to the firm as additional cash. This gap must be financed with debt (borrowing), equity (cash on hand - owners’ capital), or some combination of the two. If the CCC is financed with debt, the impact on firm value is straightforward: an increase in the CCC increases interest expense, which increases costs and decreases the long-term profit of the firm. If the CCC is financed with cash on hand (i.e. with equity), there are still costs to consider. Cash tied up in the operating cycle is not available for other purposes, which may cause the firm to forgo otherwise profitable opportunities such as taking on additional profit-earning projects. Shortening the CCC means more cash is available cover unexpected expenses and take advantage of profit-earning opportunities.
Managing the CCC
Let's dig into the three individual components of the CCC and see what opportunities exist to shorten the cycle. The first component, Days Inventory Held (DIH), can be thought of as the average number of days material sits waiting for installation, including prefabricated material. This is one of two components a firm can easily influence to shorten the CCC. We've written about how metering the flow of material to the job site increases cash on hand, reduces DIH, and shortens the CCC. See the previous articles here, here, and here (clicking the links opens each article in a new window).
The second component of CCC, Days Sales Outstanding (DSO), aka the collection period, is the average number of days it takes to receive cash from clients after submitting a pay app. It is common for non-prime contractors to wait 90 or 120 days to receive payment. Contractors have little influence over this component of the CCC, particularly as non-prime contractors. This is long period compared to other industries and is a significant factor in the low survival rate for commercial construction contractors. A comparatively long collection period makes measuring and managing the other two CCC components particularly important for construction firms.
The “2005 Surety Credit Survey for Construction Contractors: The Bond Producer’s Perspective” cited low profit margins, followed by slow collections and insufficient capital as the major causes of financial difficulties among contractors.
- "Why do contractors fail?" https://www.constructionbusinessowner.com/insurance/insurance/why-do-contractors-fail
The third and final component of the CCC, Days Payable Outstanding (DPO), is the average number of days the firm takes to pay vendors for material after receiving the invoice. DPO is subtracted in the overall CCC metric, so lengthening this time would decrease the CCC , but there is a very good reason for keeping DPO short: Vendor discounts.
Vendors typically offer terms such as 2/10 net 30. That is, you can take a 2% discount if you pay the invoice within 10 days, otherwise the full amount is due in 30 days. While 2% may not sound like much, we have to keep in mind that this is 2% over twenty days. That is, if you take an additional 20 days to pay (pay on day 30 instead of day 10), you have to pay an extra 2%. That works out to an annual interest rate of 36.73%!  In other words, the vendor is charging you an annual rate of 36.73% if you wait until day 30 to pay the invoice. Even if you don't have cash on hand to pay within ten days, you will save money borrowing on a line of credit to get the 2% discount, assuming your annual borrowing costs are less than 36.73%.
Shortening the CCC offers tangible value for commercial construction firms. A shortened CCC translates to more cash on hand in a given period and reduced borrowing costs for firms that must finance the CCC with borrowing. It also means that more cash is available in a given period to pursue additional projects that would otherwise be unavailable, which leads to higher long-term profit.
Of the three CCC components, Days Inventory Held (DIH) is the only one that a contractor can or should manage in order to shorten the CCC. Contractors have little influence Days Sales Outstanding (DSO) and contractors have a strong incentive to shorten one Days Payable Outstanding (DPO). We invite the interested readers to view our previous articles on Additive Project Management for strategies to reduce DIH (See the previous articles here, here, and here - clicking the links opens each article in a new window).
-Steven Stelk, PhD, FP&A; Financial Strategist, Cycle Rate Performance
 CCC = DIH + DSO – DPO. DPO is subtracted from (DIH + DSO) to calculate the CCC, so increasing DPO would decrease the CCC
 Free cash flows is defined as cash flow available to owners and creditors after funding all operating expenses and capital expenditures. This is a more precise definition of the general concept of profit = revenue - expenses.
 See https://www.thebalancesmb.com/the-cost-of-trade-credit-accounts-payable-392835 for a detailed calculation.