Cash conversion cycle definition
/What is the Cash Conversion Cycle?
The cash conversion cycle measures the time period required to convert resources into cash. The intent behind the measurement is to determine how long invested funds are tied up in the production and sales processes. A short duration cash conversion cycle allows a business to be operated with a smaller up-front cash investment. The factors used to derive the cash conversion cycle are as follows:
The average time required to pay supplier invoices
The average time required to convert raw materials into finished goods
The average time required to collect receivables from customers
The Cash Conversion Cycle Formula
The cash conversion cycle formula is as follows:
Days inventory outstanding + Days sales outstanding - Days payables outstanding = Cash conversion cycle
The calculation of the various components of the cash conversion cycle are as follows:
Days inventory outstanding = (Average inventory ÷ Cost of goods sold) x 365 Days
Days sales outstanding = (Accounts receivable ÷ Annual revenue) × Number of days in the year
Days payables outstanding = Ending accounts payable ÷ (Cost of sales ÷ Number of days)
How to Compress the Cash Conversion Cycle
Of the various elements of the cash conversion cycle, the one most amenable to significant change is the days of inventory outstanding. Receivables figures tend to vary little, while payables payment terms are dictated by existing contracts with suppliers. Consequently, an astute management team will focus its attention on shrinking the investment in inventory.
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How the Cash Conversion Cycle is Used
The cash conversion cycle is typically used as part of an analysis of how the investment in working capital can be reduced. This can result in a number of operational and policy decisions, such as:
Outsource production, to avoid an investment in inventory. This can represent a massive reduction in cash requirements, because it also allows the firm to eliminate all of its capital investment in fixed assets in the production area, along with any associated real estate.
Install a just-in-time production system, to reduce the inventory investment. Depending on how aggressively this strategy is pursued, a company may be able to reduce its on-hand raw material inventory levels to just what is immediately needed on its production lines.
Cancel poorly selling products, thereby eliminating the associated amount of supporting inventory. However, doing so may open up holes in the company’s product lines, which could drive away customers.
Tighten the credit policy, to reduce billings to customers less likely to pay on time. However, this can drive away customers with somewhat weaker credit who might otherwise have contributed to the firm’s profitability.
Alter the collection procedures to enforce more rapid customer contacts regarding overdue accounts. One might also shift overdue accounts more rapidly to collection firms, which are more aggressive in their collection activities.
Negotiate with suppliers to lengthen payment terms. However, a common outcome of this process is that suppliers demand somewhat higher prices in exchange, so that the net effect is reduced.
A short conversion cycle is considered highly desirable, since it means that a business can be operated with a reduced amount of cash. A company with a shorter conversion cycle than its peer group probably has reached this point due to a continual review of the entire process over a long period of time. At a minimum, a responsible manager may want to track the conversion cycle on a trend line, and take action whenever the cycle indicates that it is taking longer to convert invested funds back into cash.
The cycle is also closely monitored in smaller organizations that have minimal amounts of equity financing or debt financing. These businesses have so little excess cash that they must be mindful of how their cash is being used. This is a particular problem for nonprofit entities, since they usually have small cash reserves.