It can be difficult for a start-up company to get funding because of the risk involved for investors and banking institutions. However, an effective way to increase cash flow can be to optimize the cash conversion cycle.
The sooner you sell your product, the sooner you can increase your profits. There is no need to take out a loan to do this. Today, many start-ups rely on self-financing. It is not without risks, but the benefits are worth it.
What Is Self-financing Capacity?
Self-financing capacity is the value that defines whether or not a company is able to produce its own internal resources.
Analysis of this value must be done in order to foresee the financial risks of self-financing. Using a financial professional is the best alternative to avoid mistakes.
What Is Self-Financing?
Self-financing of a company means that it obtains liquidity without obtaining financing from third parties. This liquidity is obtained through the company’s own funds, its profitability, savings and its accounting depreciation.
The company does not need any external help to carry out its activity. The company does not need to :
- Apply for a bank loan
- Apply for a government grant
- Ask for an investor
Of course, choosing this method of financing can be risky:
- Inability to manage the unexpected
- No tax deduction
- Slow operating cycle
- Slow cash flow
However, the benefits can be worthwhile:
- No loan repayments
- Financial independence
- Monopoly of management and decisions are made by the director
Why Do Startups Use Self-Financing?
Self-financing means being free to manage one’s own actions. The manager does not have to bend to the will of the shareholders who tell him the strategy to follow to “succeed”. His main goals remain respected.
A self-financing company has several benefits:
- In case of loss, there is no need for repayment
- If the business is successful, the manager can invest in another project and expand his business
- The manager is the only master on board
What Is the Cash Conversion Cycle (CCC)?
The cash conversion cycle observes the number of days in which a company is able to convert the realization of a sale and therefore an inventory outflow into cash (inventory turnover), collect its accounts receivable (accounts receivable turnover) and pay its accounts payable (accounts payable turnover).
Actually, the CCC is the sum of these three components. All three components are measured in number of days.
How To Calculate Your Company’s Cash Conversion Cycle?
The conversion cycle can be calculated by the company’s manager or accountant. All he has to do is to collect all data to be taken into account in the operation. Any self-financing entrepreneur should be able to master this part of the management of his company. To do so, it is necessary to consider these key points:
Inventory Turnover Ratio
The inventory turnover ratio is obtained by multiplying the number of days in the observed period with the average inventory ratio divided by the annual cost of sales.
Average inventory is the average of the beginning of the year inventory balance and the end of the year inventory balance. Generally, the convention is to observe the cash conversion cycle on an annual basis. We therefore take 365 days in our period.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio is obtained by multiplying the number of days in the observed period with the average accounts receivable ratio divided by the annual revenue. The average accounts receivable is the average of the balance of the accounts receivable at the beginning of the year and the accounts receivable at the end of the year. We always take 365 days in the period.
A small accounts receivable turnover ratio suggests that the company is able to get payment quickly from its customers. A decrease in both of these factors naturally increases the company’s liquidity, as it contributes to a rapid conversion of sales into dollars.
Accounts Payable Turnover Ratio
The accounts payable turnover ratio is obtained by multiplying the number of days in the observed period with the average accounts payable ratio divided by the annual cost of goods sold.
The average accounts payable is the average of the balance of accounts payable at the beginning of the year and the balance of accounts payable at the end of the year. We take another 365 days. The calculation of these three components allows us to obtain the number of days required to transform the associated balance sheet account into income or expenses.
A high accounts payable turnover ratio tends to decrease the cash conversion cycle and therefore increase the company’s liquidity. In fact, a longer accounts payable turnover ratio suggests that the company is stretching the payment of accounts payable by making optimal use of the terms.
Cash Conversion Cycle
The Cash Conversion Cycle is the (inventory turnover ratio + accounts receivable conversion ratio – accounts payable conversion ratio). You can calculate your cycle using this formula.
A company that finances itself internally by optimizing the cash conversion cycle will therefore have a cycle that tends towards zero and may even be negative. In fact, small inventory and accounts receivable turnover ratios suggest that the company is able to sell its inventory quickly.
Importance of the Cash Conversion Cycle for Small Businesses
It might be relevant to look at the cash conversion cycle, but to have explanatory power, this ratio should be compared over time, via the comparison of three components:
- The inventory ratio
- Accounts receivable conversion ratio
- The accounts payable conversion ratio
This analysis can give a good idea of whether your internal cash generation is improving or deteriorating. In fact, it is the best way to know if you are getting money back fast enough or too slowly.
This way, you can be more disciplined in your strategic planning and operational risk control. It will then be easier to consider a change of direction or a new strategy to increase your profitability.
Need Help with your Financial Management?
Managing the legal and financial aspects of a business is not an easy task. A lot depends on it. If you are thinking of self-financing, it is wiser to leave the work to an expert so you can focus on the deployment of your project and its key activities. This way, you won’t waste your equity and you’ll be well taken care of with every investment you plan to make.
Cofinia offers several services to help you manage your business:
- Accounting: Our service includes bank reconciliation, financial statements, adjustment, budget management (working capital), expense account, inventory, tax remittance, payroll management, and budget analysis.
- Financial Modeling: This service includes income statement analysis, balance sheet analysis, and cash flow analysis for your company.
- Business Intelligence: This service includes the use and integration of automated tools such as Zoho software.