The best way to understand this concept is to think of it as the length of time you have funds invested in inventory and labor before you receive payment. This concept applies to services, retail or wholesale sales, manufacturing, or to projects undertaken for the client.
For services such as architecture, accounting, legal and many others the investment of funds is primarily salary and benefits for the people performing the service. For wholesale or retail trade the investment is primarily material and some labor, depending on the specific situation. For manufacturing and projects there is often a combination of both material and labor.
In addition to these sale specific items there is also the expenditure of normal operating expense not associated with the production of goods for sale.
One factor that is extremely important are the gross margins earned on the sale. Gross margins are the difference between the sales price and the direct cost (material and labor) to produce that item for sale.
A higher gross margin means there is less investment in producing the product for sale. Conversely, a lower gross margin means a higher investment in producing the product for sale.
What follows is the computation of the period of the investment. The starting point is when the first dollar is spent for material or labor. Each dollar of material and labor spent is added together to determine the total investment. The amount of time that it takes to complete the production of the good or service is also determined. If work on the product begins on July 1, XX and ends on July 30, XX then there are 30 days that the money is invested. During this period the whole amount is not invested for the full period. There are varying ways to handle this but for simplicity you can take the total number of days and divide it by two (2). In this example that would be 15 days.
The next period of time is measured from the time the item is completed until payment is received for that item. That is why accounts receivable (the amount you are owed by customers) management is very important. This will be discussed in the next cash flow post. If it took 30 days to produce the item and you receive payment 60 days later then you have a total of 75 days that you funded the investment (remember to reduce the production time by half).
This would mean that you would have to have available cash for the entire 75 day time period from inception to collection to fund production of the item. If you are working on multiple items then there costs would have to be added together to determine the cash you would need to have available to fund the production of items for sale.
This is why working capital (accounts receivable, inventory, and accounts payable), which we saw in the last post has a negative return, needs to be minimized. This is another way that successful companies can fail – by growing faster than their cash flow can support.