The Art of Collecting Cash

An interesting tidbit was posted on the Johnson & Johnson (NYSE: JNJ) discussion board last week (free trial required to read). Fool Community member 38Packard said that J&J's Business Services unit is changing its bill payment policy.

"Yawn," you might be thinking. "Big yawn," even.

But really, this is interesting. A company has financial advantages the sooner it receives payment for products and the later it pays its bills. The Rule Maker Portfolio has written about this for years. If a company -- and Amazon (Nasdaq: AMZN) is a good example -- gets paid for sales up front and doesn't pay suppliers for, say, 30 days, then its daily operations can basically be financed by its suppliers.

Of course, companies still need to make more money than they pay out, but when a firm is paid for sales before it pays for the product it sells, it has much more financial flexibility. This situation is called having a negative cash conversion cycle (CCC). A cash conversion cycle shows the number of days that it takes a business to turn a dollar paid for inventory into a dollar of income.

So, back to 38Packard's post. 38Packard is a vendor to Johnson & Johnson. J&J buys from him and he submits bills to J&J. He wrote that in the past J&J paid the bill in "Net 30" -- meaning the whole amount was paid within 30 days. However, J&J is so large that it can make new rules and not lose business, and so it's now stretching out its payment schedule -- by 50%!

J&J's new Business Services payment schedule is:

Net - 45 days
2% - 30 days
4.5% - 10 days

This means that if a J&J vendor wants full payment, they should expect to wait 45 days now, rather than 30. If a vendor demands payment in 30 days, that's fine, but J&J will only pay 98% of the bill (2% will be deducted). If a vendor wants payment in 10 days, that's okay, too, but J&J will only pay 95.5% of the balance. See how that works? Either way, J&J wins.

38Packard said that he opted for "Net - 45 days." He'll be fully paid, but he'll need to wait 15 extra days compared to before. Meanwhile, J&J will use both his product and his money to its advantage.

What results? J&J's CCC should significantly improve.

Cash conversion cycle
Imagine you run a coconut stand. Each week, you pay $100 for coconuts. You want to know how long it takes for that $100 spent to become $100 in your pocket. You need to run your CCC. How? Glad you asked. We'll show you with J&J and Pfizer (NYSE: PFE).

Today, we'll figure both companies' 2001 CCC. In January, we'll look at 2002 results to see if they improve. The lower a company's CCC number, the better. In fact, a negative number is desired. A negative number indicates that a business is turning product into cash before it -- you guessed it -- pays for the product. 

Bill Mann (TMF Otter) explained the mechanics of CCC very well last August. Following is a three-step tutorial (free of charge or guilt) for figuring a company's CCC. Are you ready for some excitement? You better be!

1. Days inventories outstanding (DIO)
First we deteremine the number of days it takes for a company to run through its existing inventory. This is called "turning" its inventory. We go to Fool Quotes and Data and pull up 2001 annual SEC filings for J&J and Pfizer. (Table numbers in millions except DIO, DSP, and DPO.)

                        J&J      Pfizer
Cost of Goods Sold      9,536    5,037
COGS per day               26     13.8
   (annual COGS/365)
Inventories             2,992    2,741      
DIO                       115      198

See, there we divided inventories at year-end ($2.992 billion for J&J) by cost of goods sold per day ($26 million) and find that J&J had 115 days of inventory at year-end. Pfizer had 198 days.

2. Days sales outstanding (DSO)
Now we must find the average amount of time that it takes for each company to receive payment after a sale.

                        J&J        Pfizer
Revenues                33,004     32,259
Revenues per day          90.4       88.3
    (annual revs/365)
Accts. Receivable        4,630      5,337
DSO                         51         60

Here, we divided accounts receivable by revenue per day to find how long it takes, on average, for our companies to be paid. J&J rings in at 51 days to Pfizer's 60.

3. Days payable outstanding (DPO)
Finally, to get the CCC, we subtract the number of days that it takes a company to pay for the product it has received.

                         J&J       Pfizer
Cost of goods sold       9,536     5,037
COGS per day                26      13.8
(annual COGS/365)
Accounts payable         2,838     1,579
DPO                        109       114

To find this number, we divided accounts payable by COGS per day. We're almost done. To get the CCC, we add the DIO, DSO, and DPO results, remembering that DPO is always turned into a negative number. Hence:

J&J's cash conversion cycle: 115 + 51 + (109) = 57 days

Pfizer's cash conversion cycle: 198 + 60 + (114) = 144 days

So, in 2001, a dollar spent on goods sold at J&J was turned into cash in 57 days; Pfizer took 144 days.

Conclusion
Pharmaceutical companies typically have longer cash conversion cycles than, say, retailers that are paid up front by shoppers. Drugs are sold well in advance and long before collecting payment, because doctors stock weeks of supply on generous payment schedules. That said, J&J's CCC of 57 days is decent to quite good, and will likely improve. Pfizer's CCC is high, even when accounting for its heavy pharmaceutical focus. It has been "high" for a long time, as we've written on the Fool before. This doesn't mean it's a poor business, or that J&J is better, but it's something to keep an eye on. What you want to watch out for (see the bottom of the article just linked to, about Lucent (NYSE: LU)) is a CCC number that rises higher and higher over time. That's a warning sign. We'll watch for this with our companies.

Try running some CCCs for your companies. When you run CCCs, just remember that results vary greatly between industries, and though a negative CCC number is best, it doesn't mean that a company is a winner. Many companies with negative CCCs are underperformers, sometimes selling low-margin commodities. Finally, you can run these numbers quarterly for more timely results -- just divide by 90 days rather than 365.

We'll revisit our companies' cash conversion cycles early next year. To discuss this column, visit the Pfizer and J&J boards linked to the right.

Have a great holiday!

Jeff Fischer will settle his monthly bills by paying 60% of the balance no later than 90 days after the due date. What? What's wrong with that, AT&T? Jeff owns share of J&J and Pfizer. The Fool has a disclosure policy.