Friday, March 16, 2007

Increasing Cash Velocity using Theory of Constraints

Cash velocity is a component of the wider topic of cash flow. Both cash flow and cash velocity are like good health. When you have it, you don’t really notice. But for many companies the time between when they have to pay their vendor and when they get paid is large and getting larger. In many industries customers are pushing out payables to improve their cash positions, thereby reducing yours.

To stay clear of cash troubles we need to understand cash velocity and investigate some strategies to increase it. So let’s jump right in!

Cash velocity is the throughput (T) you generate divided by the time it takes to generate the throughput. Throughputis the selling price of your product/service minus what you paid your vendors (your TVCs[1]) to generate and sell your product/service. The time it takes to generate the throughput is the cash-to-cash cycle time. Cash-to-cash cycle time (CtC) is a ratio that serves to highlight the amount of time a company must finance raw material. It is the time between when you spend money[2] necessary to produce your product or service until you get paid from your customers for the finished goods or services.

You can impact cash velocity by:

  • Increasing your throughput
  • Decreasing your cash-to-cash cycle time

The rate (or velocity) at which you generate throughput is as important, and at times may be more important than the dollar amount of throughput. Generating $100 of throughput in 30 days, a velocity of 3.33, is much different than generating $80 in 10 days for a velocity of 8. The higher the rate or faster the velocity, the better. For that reason, let’s first focus on decreasing cash-to-cash cycle time.

[1] TVCs are those costs that are incurred because you produced and sold one of your products or services. They include things like raw materials, subcontracted services, freight, sales commission. See Goldratt's Throughput Accounting as developed in Theory of Constraints.
[2] When you pay for your TVCs.

tune in on Monday for more ...

(c)Copyright 2007, Dr Lisa, Inc. All rights reserved.

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