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Managing Your Balance Sheet – Your Cash Cycle

Most owners are always anxious to receive the monthly financial on how their company is doing.  Almost inevitably they turn immediately to the income statement and go to the bottom line to see what the net income was.  Then they spend a lot of time reviewing the sales levels and margins and look for variations in expense accounts.  This is all well and good, but oftentimes their review stops there and they ignore the balance sheet and other financial information. Although net income is an important driver of the business, cash flow is probably an even more important driver and nothing affects cash flow more than the balance sheet.

The Balance Sheet can be a “Cash Sponge”

If the balance sheet isn’t managed, it can soak up cash flow. Increases in sales can result in accounts receivable and inventory increases, but those increases should be in proportion to the sales increase.  Oftentimes, to meet the demand of increased sales, inventory and sales procedures take a back seat and vendors are paid sooner resulting in substantial drains in cash flow as the cash is locked up in the balance sheet accounts. 

Looking at the gross amounts in inventory, receivables and payables often isn’t very meaningful.  Much like looking at cost of sales alone isn’t as meaningful as when you look at it in relation to sales and can determine whether your gross margin is improving or not.  So, when looking at your balance sheet accounts you should review in relation to an income statement.

Calculating Days

The relationship between balance sheet accounts and income statement accounts are normally expressed in turns and further refined into days.  For instance calculating receivable turns and days would be done by dividing receivables into sales (the “turn”).  To get to days you would divide 365 (days in a year) by the turn. 

An example: a Company with annual sales of $12 million has ending receivables of $1.2 million.  That is a turn of 10 ($12 million of sales divided by $1.2 million of receivables).  The days would be 36.5 (365 days divided by 10 turn).  Inventory and payables would be based on the relationship to cost of sales.

Do You Know Your Cash Cycle?

If you think about cash flow generated from sales, a company’s cash flow cycle is composed of the following elements. The Company must carry enough inventories to have product on hand to meet the sales order “Days in Inventory”.  It normally doesn’t have to pay it's inventory vendors right away as the inventory gets delivered and then the invoice is sent and payment is remitted.  The spread between when the inventory is received and payments are made is “Days in Payable”.   Once the product is built, it is shipped to the customer who doesn’t pay it right away but at a later date based on the term of sales Days in Receivables”.    So the amount of days you are out of cash is your Cash Cycle:

Cash Cycle = Days in Inventory -- Days in Payables + Days in Receivables

As sales increase, the gross dollars locked up in the cash cycle will increase but if you manage the cash cycle the days in the cash cycle should stay the same. 


So now that you know your cash cycle days, how do you determine if they are favorable or unfavorable?  It’s easy to compare your receivables and payables days to the terms established.  Are you collecting your receivables slower than you're paying your vendors? After all, you are a vendor to your customers.  Normally, receivable terms are due on demand or within 30 days, yet normal industry data on receivables is close to 45 days. 

Inventories are not as easy to benchmark as companies production and purchasing practices can be quite different. Distributors buy finished product vs. a manufacturer who has to buy raw materials, and produce their product which normally takes a longer time.  In these cases, the best benchmarking would be to compare to others in your industry through trade groups or industry data such as Robert Morris, or other services. (We can provide data based on your industry if you would like.)


Improving cash flow starts with being cognizant of your cash cycle and paying attention to internal procedures when the cycle starts to get longer. 

Further improvement to your cash flow cycle can be accomplished in many different ways from cash management systems, lock boxes, inventory ERP systems, offering discounts, etc. 

Much like taking an annual physical for your health, an annual cash flow check-up will keep your company focused on not only managing the income statement but also the balance sheet.

10 Keys to a Healthy Business

Bill Smith is a Vice President of the Assurance Services Group. In his spare time Bill enjoys golf, boating and volleyball.

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