A business can be profitable on paper and still constantly feel short of cash.
One of the reasons for this is the cash conversion cycle, which is essentially the time between a business paying out cash to deliver its product or service and receiving that cash back from its customers.
The longer that cycle takes, the more working capital the business needs to fund its day-to-day operations.
Understanding this cycle can help business owners identify where cash is getting tied up and, importantly, what they can do about it.
Profit and Cash Aren't the Same Thing
Consider a business that completes $50,000 of work during the month.
From an accounting perspective, that $50,000 may be recognised as revenue and contribute to the month's profit. But if the customers don't pay those invoices for another 30, 60 or 90 days, the cash isn't actually available to the business.
In the meantime, wages, suppliers, GST, rent and other expenses still need to be paid.
This gap between earning revenue and actually receiving the money is one of the reasons a growing business can experience increasing cash flow pressure even as its profitability improves.
What Is the Cash Conversion Cycle?
At its simplest, the cycle looks something like:
Cash → Stock or Work → Sale → Debtor → Cash
The exact cycle will differ between businesses.
A retailer might purchase stock, hold it for several weeks, sell it and then receive payment immediately.
A construction or trade business might purchase materials and pay staff before completing the work, invoice the customer afterwards and then wait another month for payment.
A professional services business may have very little inventory but considerable work in progress before an invoice can even be raised.
The important question is:
How long does it take for $1 leaving your bank account to come back as cash from a customer?
Where Does Cash Get Stuck?
There are several common areas worth looking at.
1. Stock
Holding too much inventory ties up cash.
Stock sitting on a shelf may be an asset on the balance sheet, but it doesn't help pay wages or tax until it has been sold and converted back into cash.
Looking at slow-moving or obsolete stock can therefore be just as important as looking at sales.
2. Work in Progress
For service, trade and project-based businesses, work in progress can be a significant drain on cash.
If the business completes substantial work before issuing an invoice, it is effectively financing that work itself.
Progress invoicing, deposits and more frequent billing can potentially shorten this part of the cycle.
3. Debtors
The next delay occurs after the invoice has been issued.
If your payment terms are 20 days but customers routinely pay after 40 or 50 days, that additional period has to be funded by the business.
As discussed in our earlier article on debtor management, improving invoicing and collection processes can make a meaningful difference to cash flow without requiring a single additional sale.
4. Supplier Payment Terms
The other side of the equation is when you have to pay suppliers.
There can be a significant cash flow difference between paying suppliers immediately and having appropriate commercial payment terms.
The objective isn't simply to delay paying bills. It's to make sure the timing of payments is sensibly aligned with the business's own cash cycle.
Growth Can Actually Make the Problem Worse
This is where cash flow can become counterintuitive.
Imagine a business winning substantially more work.
To deliver that work, it may need to purchase additional materials, employ more staff or contractors and carry more work in progress.
If the additional customers don't pay for several weeks, considerably more cash can become tied up before the business receives the benefit of that growth.
That's why rapid growth can consume cash rather than immediately create it.
A profitable and growing business can therefore still need additional working capital.
Small Improvements Can Release Meaningful Cash
You don't necessarily need to completely redesign the business.
Improving several parts of the cycle at the same time can have a significant cumulative effect.
For example:
invoice immediately when work is completed
use deposits or progress payments where appropriate
actively follow up overdue debtors
review slow-moving stock
reduce unnecessary stock holdings
review customer payment terms
negotiate appropriate supplier terms
regularly review work in progress.
Even reducing the overall cash cycle by a relatively small number of days can release cash that would otherwise remain tied up in the business.
A Useful Number to Monitor
Most business owners regularly look at sales and profit.
But it's also worth asking:
How much money do I currently have tied up in stock, work in progress and debtors?
And then:
How quickly are those balances turning back into cash?
Tracking these figures over time can highlight problems well before they become obvious from looking at the bank account alone.
Cash Flow Is About More Than Sales
When cash is tight, the natural response is often to focus on generating more sales.
Sometimes that's the right answer.
But before chasing additional revenue, it's worth looking at the cash already sitting within the business.
Improving the cash conversion cycle can strengthen cash flow without necessarily increasing sales, margins or borrowing.
For a growing business in particular, understanding how quickly profit converts into actual cash can be just as important as understanding the profit itself.