258 ENTREPRENEURSHIP
between the time the entrepreneur receives supplies and the time she has to pay for these
supplies (account payable) is a source of financing. Here it reflects the time from the
receiving of materials until approximately half of them are used. Segment 2 represents
the time period in which raw materials remain in inventory. This segment corresponds
to the time from their entry into raw materials inventory to the time they enter work-
in-process (WIP) inventory. WIP inventory represents the partially completed product
that is still being worked on.
Segment 3 represents the time when WIP goods are counted in inventory. They are
now finished goods. Segment 4 represents the time goods spend in finished goods inven-
tory, and segment 5 represents the time that goods that have been sold are in receivables.
Figure 7.1 gives the formulas for calculating each of these ratios. The figures used to
calculate these ratios are found on the pro forma balance sheet and income statement for
the new venture or on the actual financial statements for the existing business. The total
length of the short-term cash cycle is given by the sum of segments 2 through 5 minus1. MedTrack
Figure 7.2 illustrates the significance of these ratios. The top shows a typical cash flow
cycle for a sample firm, and the bottom half depicts a “controlled” cash flow cycle with
much of the slack and waste removed.
6
The top half of Figure 7.2 indicates an uncontrolled cash flow cycle of 120 days. The
firm, through debt or equity, must finance every dollar of sales for 120 days. What does
this mean in terms of firm profitability? If the firm has $5 million in sales before con-
trolling the cash flow cycle, the net working capital required for 120 days of sales value
would be approximately $1,643,836 [($5,000,000/365) x120]. The bottom half of the
figure shows a hypothetical “controlled” cash flow cycle. After control measures are
introduced and the cash flow cycle is tightened, the required working capital is reduced
to $616,438 [($5,000,000/365) x45]. Where has the difference of over $1 million
gone? Typically, it goes to reduce debt or to be invested in other assets that can increase
sales. For example, Figure 7.2 shows a marked reduction in the time it takes to process
work-in-process (WIP) inventory (segment 3: 40 -25 = 15, 15/45 = 37.5 percent).
The reduction in working capital requirements could be used to retire the debt incurred
to purchase the machine that made manufacturing so much more efficient. This illus-
trates one of the dramatic effects of tightly managing the venture’s cash: Investments can
be made to pay for themselves very rapidly.
Another way of seeing the dramatic benefits of cash management is to imagine that
the owner of this hypothetical company needs to raise $1 million from venture capital-
ists in order to expand the business. Venture capital often requires rates of return of be-
tween 30 and 50 percent. If the entrepreneur can raise the $1 million through improved
cash management techniques, the firm will save between $300,000 and $500,000 per
year in finance charges (dividends) paid to the venture capitalists. If the firm is netting
10 percent on sales of $5 million ($500,000), the cash control measures are the equiv-
alent of increasing profitability between 60 and 100 percent.Managing and Controlling the Cycle. Many excellent books detail the steps in the
process of managing and controlling the cash flow cycle, so we will only summarize