Cash Conversion Cycle: Creating a formula for success

Sept. 28, 2021
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In early 2020, I was working in a hospital with the supply chain staff as part of a standard review of their inventory spend. Fast forward six months when the world was well into the COVID-19 pandemic, this same hospital’s inventory spend had escalated by 10 times the original amount.

This was not an isolated occurrence; it happened in many hospitals across the United States that were proactive in obtaining personal protective equipment (PPE) and other needed supplies during the pandemic. Products became scarce as hospitals across the nation stockpiled.

Another unforeseen consequence of the pandemic was the dearth in elective procedures. These procedures were cancelled or delayed for several months in 2020 to have the capacity, PPE and other supplies as well as staff to treat COVID-19 patients. Today, delays are still ongoing, and the cancellations have led to an overstock of items, which creates the potential for expiration on some devices.

Healthcare organizations are now in a difficult position with excess inventories (working capital) of certain supplies, such as catheter/balloons, endo mechanicals and suture, and custom procedure packs in storage, and an uncertainty of elective procedure patient volume coming back to pre-COVID levels in the near term. To get beyond this scenario and improve management efficiency, liquidity and overall financial position, organizations can use a metric called the cash conversion cycle (CCC). The supply chain has a role to play in this effort.

Do the math: How to calculate your CCC

Traditionally, healthcare facilities measure liquidity by these ratios: quick, current and days cash on hand.

  • Quick ratio = liquid assets/current liabilities
  • Current ratio = current assets/current liabilities
  • Days cash on hand = annual operating expenses/365

These are useful metrics, but they are static.

While the current ratio assumes the sale of inventory to pay current liabilities, the quick ratio excludes inventories, and neither speaks to the time element. Days cash on hand only looks at available cash and does not consider the inventory/working capital.

To incorporate the element of time and focus on inflow and outflow of dollars, as well as the timing of those inflow and outflows, you need to use the cash conversion cycle or CCC.

The CCC improves the efficiency of management—how to manage inventory, receivables and payables—and can improve cash on hand by providing visibility to the finance department for areas that need improvement.

The CCC provides a measurement in days of product cycles, beginning with inventory purchases, moving on to utilization for patients, patient billing processes, payment to suppliers, and finally,  receipt of cash back into your facility. It is typically calculated on a quarterly basis—the most recent average for publicly traded healthcare companies is about 30 days. The average for all hospitals, pre-pandemic, was 64 days, according to research recently published by Soumya Upadhyay, Bisakha Sen, Ph.D., and Dean Smith , Ph.D., in the Journal of Health Care Finance.

To calculate the CCC, you need three activity ratios: days inventory on hand (DIO), days payable outstanding (DPO), and days receivable/sales outstanding (DSO).

  • DIO = 365/turn ratio
  • DPO = accounts payable/ (cost of sales/no. of days)
  • DSO = (accounts receivables/net credit sales) x 365
  • CCC = DIO + DSO – DPO.

When it comes to the ratios needed to calculate the CCC, obviously Supply Chain has control over DIO, but it also has some control over DPO. How? When supply chain negotiates the payment terms and conditions of a contract, it forges a direct link to DPO.

Strategies to optimize your cash conversion cycle

A decreasing or stable CCC is a positive metric for the direction and financial stability of an organization. Inventory with a lower turn rate will increase the CCC; inventory with a higher turn rate will decrease it. There are many different strategies that will improve the days of inventory on hand, and they should be regularly reviewed and re-implemented when necessary to manage the turns and thus DIO. Some of these strategies are:

  • reducing inventory variability, for example, by reducing the number of stock-keeping units (SKUs) in product categories.
  • increasing consignment inventory with vendor-managed inventory.
  • implementing an accurate forecasting system; improving predictive demand planning for high dollar items.
  • reviewing contract payment terms.

Supply Chain should consider these strategies if inventory is not turning efficiently and is greater than the average or benchmarked leading practices for the healthcare industry—12 inventory turns in a year for cardiac catheter labs and seven to 12 inventory turns for operating room or surgical services. These strategies can assist in the facilitation of a faster turn rate for all inventories and therefore a reduction of the days inventory on hand, which can lead to a decrease in days for the cash cycle to be completed.

The next area for developing a strategy is DPO, and one of the areas for your supply chain team to review, is contract payment terms. These terms can be extended to improve the CCC. If you are at 30 days for payment, you could try to extend to 45, or even 60 days.

However, if you overreach by asking for an overly long extended timeframe for payment, it could impact the organization’s relationship with these same suppliers, send a mixed message and eventually drive up costs or threaten their ability to ship. Supply Chain must strategize with the accounts payable department to determine what would be beneficial for the organization in payment terms, days to pay and discounts. Strategies include:

  • structure accounts payable, sourcing and purchasing functions and policies for improvement.
  • develop new guidelines for payment terms.
  • review payment terms for discounting.

This remains a precarious balancing act for Supply Chain, which must have inventory available for use at any given time, maintaining a fill rate at target levels for critical items with a turn ratio that decreases the days of inventory on hand.

An organization will do itself a disservice if they look at DIO, DSO and DPO as standalone metrics. The CCC metric incorporates them all, and measures and evaluates management effectiveness when calculated quarterly, trended and tracked consistently. Organizations experiencing an increasing CCC should investigate their metrics to determine the root cause, and correct it.

Other industries such as automotive and retail have used the CCC metric for many years. It is now time for hospitals and healthcare organizations to look at their cash conversion cycle and comparisons within the industry. Supply Chain can assist with this. Given what hospitals have been through during the past 19 months, there is a need to reassess strategy on working capital and look for a better methodology for evaluating the effectiveness of management and financial wellbeing. The cash conversion cycle is a good place to start.