It’s easy to be mesmerized by the disruptive nature of today’s startups in their respective industries (e.g. Airbnb/Hotels, Amazon/Retail, Uber/Transportation and etc). One common thread across all of these success stories is their ability to achieve a negative cash conversion cycle - where a business is able to generate revenue from customers before it has to pay its suppliers for inventory, among other things.

This was first highlighted to me in a tweet by Bill Gurley - the legendary venture capitalist from Benchmark, which has invested in several negative cash conversion cycle businesses.

A few more tweets such as the one below prompted me to understand this concept a bit more and learn how it can be used to assess the health of any particular business.

What is a Cash Conversion Cycle? 

A cash conversion cycle is the time span between the outlay of cash for purchases (inventories and/or accounts payable) to the receipt of cash from sales. The formula itself looks like this: 

Note: The multiple (being 365 in the formula above) changes depending on the period used for COGS and Sales.

In simpler terms, the cash conversion cycle is the time it takes for a business' investments to be translated into sales and revenue. This is accounted for by looking at how quickly a business’ inventory is sold, how fast the company is getting paid for goods and services and how long the business can push off their supplier’s payments (e.g. free loan from suppliers). 

A study by Baolin Wang on the cash conversion cycle for thousands of publicly traded businesses presented a number of interesting findings. One specific trend that he found was the fact that the ‘aggregate’ cash conversion cycle (see red line in the graph below) has declined over the past twenty years.

This is likely a result of advancements in e-commerce and payment technology as well as the ability to finance outside of traditional asset-backed methods. This has led to a number of businesses to be able to operate with a negative cash conversion cycle. As mentioned previously, this is when a business generates revenue from customers before it has to pay its suppliers for inventory, among other things. 

Amazon’s Ability to Build A Negative Cash Conversion Cycle

The most prevalent example of this is Amazon. From a very early stage (see Jeff Bezos’ first shareholder letter), the company was focused on driving capital velocity and stronger returns on invested capital. Despite being ridiculed for operating at a low profit, the graph below shows how Amazon was able to grow its operating cash flows at an extremely high level. 

Alex Taussig from Lightspeed Venture Partners explains how Amazon was able to build this advantage. “My understanding is that it created a virtuous cycle. Amazon’s investments in distribution center technology lowered Days Inventory Outstanding (DIO). This allowed it to invest more cash in growth. Its market power with vendors increased with growing scale. That market power translated into better vendor terms, which led to a higher Days Payable Outstanding (DPO). Higher DPO created more incremental cash flows, which it invested in better distribution center technology. And, so on…”

Disruptive Companies Often Have a Negative Cash Conversion Cycle

There are several companies that took Amazon’s playbook and applied it to different industries. Take a look at the table below for more details: 

Assessing a Company’s Cash Conversion Cycle

While it is fairly easy to calculate a public company’s cash conversion cycle, it is far more difficult to understand the cash conversion cycle for a private company (particularly a startup/scale-up). This is largely due to the availability of such information during the formative stages of the company (e.g. it’s hard to get a sense of working capital when the company is still trying to identify product-market fit). Although it is far easier to focus on high level metrics such as total revenue, MRR or number of users, it is important to assess the business by asking questions around what the cash conversion cycle looks like. I have listed some questions that will help get an understanding of what the business’ cash conversion cycle could look like. 

Sales Cycle

1) How long is the company’s sales cycle? 

2) How does this vary by channel? 

3) What is the company’s cost of acquisition by channel? 

Supplier Relationship 

1) How many suppliers does the company have? 

2) How is the relationship with the supplier? Who has control in the relationship? 

3) Do they offer extended payment terms? 

4) Does the company need to hold inventory? 

Collections 

1) How effective is the business in collecting cash? 

2) Is it possible to get paid before delivering the product/service? If so, what % of the revenue base comes from ‘upfront’ payments?

Financing 

1) How does the business finance itself? 

2) What is the mix of equity vs. debt financing? 

3) Is there an opportunity to do cash flow based funding? 

Note: Even if it’s too early for the business to report on its cash conversion cycle, it is important to get the management’s opinion on how they plan on executing/improving its cash conversion cycle. 

Conclusion

While it is easy to assess a business using vanity metrics such as revenue, profit, number of employees and even valuation, the core purpose of a business is to generate long term shareholder value. From this perspective, a business’ ability to quickly convert working capital investments into cash is critical. While the term ‘cash conversion cycle’ may seem rather daunting, people who are making a significant commitment to a business (whether its time or money) should really assess its ability to generate revenue from customers before paying to build and deliver the solution.