What Costco can teach you about cashDecember 24, 2013: 5:00 AM ET
Mastering the cash conversion cycle can speed your company's growth.
By Verne Harnish
FORTUNE -- Every business can learn an important lesson from Costco. The fast-growing warehouse retailer did $103 billion in sales in the fiscal year ending in September, with pre-tax earnings of $3 billion. Membership fees brought in $2.3 billion -- equal to about 75% of its profit.
That influx of cash helps the company pay for new stores, where it looks to get about a 15% cash-on-cash return on investment in building them. And renewals show no signs of slowing down. "Our membership renewal rates have gone up each year and now exceed 90%," notes CFO and executive vice president Richard Galanti. That's not surprising, given that Costco only charges customers a markup on its products of about 11%. Those in Costco's (COST) popular Executive Membership program, which charges a higher membership fee than its basic membership, get extra discounts and rewards -- a great loyalty builder that keeps those membership fees rolling in.
As I've written before, the first entrepreneurial law of gravity is that growth sucks cash. To fuel rapid growth, you've got to master the cash conversion cycle -- which, simply put, is the time it takes to get a dollar back that you've spent on the business. Finding a source of internally generated cash to get money into the business quickly, as Costco has done, can speed that cycle. It delays the point at which you have to go out and beg and borrow money to grow, a project that can slow you down greatly and doesn't always bear fruit.
Here are some other strategies to make the cash conversion cycle work in your favor.
1. Shorten the sales cycle. It can cost you a lot of money to go after customers. Most companies don't think about the fact that the faster you can land a sale, the quicker you can get a return on that investment (and the more likely you are to block competitors from getting there first). Get off email and pick up the phone or meet your customer face to face. Spending 20 minutes this way will bring you closer to a sale more quickly than going back and forth by email for three days.
2. Eliminate errors. Most entrepreneurs don't think about how even tiny mistakes -- anywhere from the delivery of the product to the invoice -- can slow payments dramatically. A customer who is upset about an error you made is going to be slower to pay.
Many entrepreneurial companies get sloppy about sending out invoices. They're so busy making and selling things that their paperwork starts to slip. Even something as simple as using the wrong format for an invoice can delay your payment for weeks or months at a big company.
If you can't stay on top of invoicing, hire someone to help you. This person should get to know the accounts payable people at any big companies you serve, and make sure your invoices are structured right, so they flow through clients' systems as quickly as possible. At one company I know, hiring a pro to handle accounts receivable helped cut 15 days out of its cash conversion cycle. Yes, you will have to pay an extra person to do this job -- but it's worth it. Shortchanging your accounts payable function is pennywise, but dollar foolish.
3. Rethink your business model. There may be ways you are doing business that are slowing the cash conversion cycle. For instance, many companies send out invoices every 30 days. Speeding that up to every 15 days will get cash into your company more quickly.
Not accepting credit cards can also slow the cash conversion cycle. One company I know, which makes printed circuit boards, found that it was easier and faster for clients at big corporations to buy its wares on their corporate cards -- which often had a $5,000 limit -- than to get a purchase order prepared. That sped up the cash conversion cycle dramatically.
At my own business, I ask a number of customers to pay in advance, which gives them special access to our offerings, as well as discounts. In return, this ensures that I always have a year's worth of payroll in the bank, in case of emergency.
Look for ways to speed delivery of your product or service, too. The sooner you get what you sell to customers, the quicker you can send out invoices and get paid.
Each business has unique opportunities to speed up cash flow. Uncovering the best ones will help you unlock the growth potential of your business.