Evaporating an Active Cash Constraint

By Ravi Gilani and Eli Schragenheim

Money is a critical resource as demonstrated by every company that has gone through bankruptcy or has been on the verge of bankruptcy.

Generally speaking cash is also the ultimate constraint of the public sector, as the budget dictates the maximum value that the public-sector organization, a non-profit organization by definition, is able to draw. Limiting the working capital of an organization to the extent that lack of cash limits the throughput happens also to some profit organizations.

This article focuses on companies for which the cash limitation is a direct threat on their survival. This kind of cash constraint is unique because it is imperative to find the immediate way to go out of the situation.

People who are knowledgeable in TOC are aware that any specific constraint of the organization should dictate policies and norms of behavior that could be different than with another constraint. This dependency on the constraint is even more noted when the constraint lies with cash, which prevents purchasing the required materials and the use of capacity and by that disrupts the life line of the organization. The immediate result is that revenues are blocked.  These revenues could have been used to generate more revenues and reduce the pressure on cash.  In such a case money is both the goal and the absolutely required capacity to continue the business. This is a unique situation with very critical ramifications, which should lead the management to behave differently than in any other state. When lack of cash threatens the existence of the organization all the attention of the top management is consumed in fighting one payment crisis after another.

The seemingly complicating factor of money being the goal, the constraint and the direct threat to the organization makes the TOC insights regarding exploiting the constraint and subordinating everything else to it, especially strong. The good news are that the right behavior accelerates the regaining of cash in a non-linear way. The objective of this article is to point to ways to elevate the cash constraint. It is not a constraint a company can live with for too long.  We believe that it is possible, many times, to get out of the cash constraint situation in 15-20 weeks.

The important generic insight for a survival cash-constraint situation is to understand the meaning of cash-to-cash cycle time and cash-velocity. This leads to being able to accelerate the cash-velocity and go out of the current state, even on the expense of the amount of revenues.

Cash to cash cycle time is the total time it takes from cash going out to cash coming in. In other words the time from the actual payment to a supplier until the client pays. We can measure the time by days or weeks as reasonable periods of time.

Cash Velocity (CV) is defined as the contribution-ratio of one unit of cash in one period of time.  For any business every dollar invested in materials, or for providing the capacity required for a sale, is expected to yield, on average, more than one dollar. In other words, the ratio of the cash in to cash going-out should be higher than 1. The idea here is to get the ratio for one period of time, like a day or a week.

Suppose one dollar is the cost to buy materials and the finished item is sold for $2 dollars three weeks later. So, the going out cash is doubled in three weeks and should yield 4$ in another three weeks.

How much did the invested dollar yielded after just one week? The answer is NOT 33%, because if after one week we get $1.33, then we immediately invest the $1.33 to generate more sales and then after the second week we have 1.33*1.33 = $1.7689, and after the third week we should have: 1.33*1.33*1.33 = 2.35, not 2.  In order to get the cash velocity (CV) of the situation where $1 would yield revenue after three weeks of $2 the CV = the 3^rd root of 2 = 1.259, or 25.9% contribution rate in one week.

A company that is in the state of struggling with a cash constraint has operational lines working, but it needs to invest its limited cash to buy materials and then turn them into sales. These are the main body of the truly-variable-costs (TVC), the cost saved when one unit of output is not produced and sold.  The quicker these dollars, used for TVC, are turned into Sales the amount of cash would grow until the state where the constraint moves to something else.  The ratio of S/TVC, S stands for sales, representing the contribution of $1 invested in materials to cash coming from sales.  This ratio is called: contribution-ratio.

The overhanging threat on the company is its ability to cover all the other operating expenses (OE). These are all the expenses the company has to carry to sustain the operational line alive.  Without the OE there is no basic ability to survive.  So, it is absolutely critical to have the amount of necessary OE in order to stay alive.  The rest of the limited cash is to make more cash as fast as possible, until the company reaches the state where there is enough cash to support the full market demand.  At that state the constraint might move to the market or to another resource.

The formal mathematical formula for cash velocity is: CV = ((S/TVC)^(1/n) -1).

The cash-to-cash cycle time is represented as n in the above definition.

Table 1 details the calculations for two different products P & Q.

Table 1

Parameter	P	Q
Selling price per unit (s) in $	100	80
Totally Variable Cost per unit (TVC) in $	50	50
Contribution ratio s/tvc	2	1.6
Manufacturing lead-time in weeks	2	2
Clients credit period in weeks	4	1
Total cash to cash time (n)	6	3
CV/Week =[{(S/TVC)^(1/n)}-1]*100	12.25%	16.9%

It seems that given a choice, due to the lack of cash, between selling P and selling Q, that selling Q would generate cash faster, bringing the company to go out of the cash constraint situation earlier than focusing on selling P. This is not the intuitive answer, just to hint how far are most managers from the right answer when cash appears as a constraint.

The cash the company holds at every point in time when it is in a cash constraint situation is used for two critical objectives:

1. Covering the critical operating expenses: the must-have expenses to keep going – OE.
2. Purchasing the absolutely required materials to enables sales. This is the TVC.

The minimal cash required for survival is n*OE, because whatever is purchased now will turn to revenues only in n periods. However, this amount does not leave any room for investing cash in order to get more cash. This means that once the company is left only with that amount of cash it is doomed.  Question is what is the amount of cash that still provides a valid option to survive? We like to find out what cash leaves an option that after n periods the company would still have the same amount of cash. Let’s call it adequate survival cash. So, we look for X cash that after n periods would yield exactly X cash. In the beginning we need first to put aside n*OE from the cash in order to cover the OE payments for all the periods, including the current one, until the new cash appears.  The remaining cash of X-(n*OE) is used to purchase materials to sell end items after n periods getting X in revenues, allowing us to repeat the process. The invested cash in materials would yield c*(X-(n*OE)), where c is the contribution rate, S/TVC, and we like it to be equal to X.

X = c*(X – (n*OE)) = c*X – c*n*OE

X*(c-1) = c*n*OE

X=n*OE*{c/(c-1)}

Sufficient cash means the cash at hand is enough to cover the n*OE plus having enough to purchase whatever is needed to exploit the capacity and/or the maximum market demand. If the cost of materials that fully answer all the demand or the full capacity of the most loaded resource, then it is enough cash to be considered beyond the urgent need pull the company from its cash constraint situation.

Table 2 provides sample calculations for above parameters.

Table 2

Parameter	P	Q
Contribution ratio (c) ~ S/TVC	2	1.6
Total cash to cash time (n)	6	3
OE / week in $	500	500
Cash available in $	2000	2000
Survival time in weeks	4	4
Survival cash requirement:   n*O.E.	3000	1500
Adequate cash requirement: n*OE*{c/(c-1)}	6000	4000
Cash required / week for full capacity	1000	1000
Sufficient cash requirement: n*(OE+1000)	9000	4500

What the table shows is that having on hand cash between $4,001 and $4,500 and focusing on the Q product provides a much better way to bring the organization out of the cash constraint than by concentrating on the P product. If the market for the Q product is limited, and this is what constraining the company from investing more than $1,000 per period in purchasing materials, the organization has more cash than 4,500, and the internal constraint provides enough capacity also for the P product, then the organization can improve even more.

The above example is a simplified reality.  Usually, while having on-hand only $2,000 there are already orders and materials in the pipeline.  That means the cash-flow situation needs to be clearly specified week-by-week.  But the principles are the same.

The process of going out of the cash constraint situation

In cash constraint situation, the focus on generating as much cash and as fast as is possible through effective utilization of existing cash. A small increase or reduction in cash can make or break the organization. This unique property of cash impacting throughput non-linearly could help organizations to overcome cash constraint in a very short period of time.  In most cases it may be possible to come out of cash constraint in less than three months by reducing cash to cash time, and by that accelerating the cash velocity.

Cash to cash cycle time (n) reduction has huge non-linear impact on throughput, cash availability, survival time, adequate cash requirement etc. Often just shrinking cash to cash cycle time is good enough to come out of the cash constraint situation provided the right measurements are in place.

The common TOC techniques of accelerating the flow of value to customers, through chocking the release of orders and the use of buffer management, are already good means to shorten the cash-to-cash cycle and increase cash-velocity.

Additional ways to reduce the cash-to-cash cycle time are:

Reducing the customer paying time. Giving the customer price reduction in exchange of significant faster payment is of paramount importance for achieving faster CV. It can be shown that even after providing 20% price discount to shrink customer payment time from 4 weeks to one week could exploit better the cash constraint. Of course, this might not be the right move when cash is not an active constraint.

Reducing the manufacturing lead-time is also of critical impact. While it is always good to reduce manufacturing lead-time, its impact on exploiting the cash constraint is even more critical.  Even here, when possible, on top of all the known TOC techniques, to use overtime, for extra cash, to vastly reduce the lead-time and by that accelerate the revenues, then it has to be carefully checked.

This thinking on the special devastating impact of a cash constraint, and its practical meaning for exploiting the cash constraint, is a major contribution of the five focusing steps of TOC.  Just remember the purpose here is to get rid of the cash constraint situation.  Cash is not a resource to keep as a system constraint!