Cash Conversion Cycle Measures Cash Flow Speed
Working Capital Management Efficiency Is also Measured by It
Apr 18, 2009
The typical cycle in a production operation involves buying supplies (on credit to the extent possible), converting them into goods, selling them (mostly on credit to be competitive) and collecting cash from customers.
Cash Conversion Cycle Formula
The cycle is expressed in terms of days, and is the net of:
Inventory in Days + Receivables in Days - Payables in Days
- Inventory in Days: Cost of Sales amount in the annual financial statement represents the total cost of production for the year. Dividing this amount by 365 gives the value of a day's production. The average of year opening and closing inventories is divided by the daily production value to compute how many days' production is held in inventory. ((Opening Inventory + Closing Inventory)/2) / Daily Production
- Receivables in Days: The yearly net sales amount is divided by 365 to get a day's sales. The average of the year's opening and closing receivables (debtors) is divided by this daily sales value to compute the debtor days, i.e. how many days' sales are in receivables (to be paid for). ((Opening Receivables + Closing Receivables)/2) / Daily Sales
- Payables in Days: The daily production value computed for inventory above is used again, but divided into the average of opening and closing payables (creditors) to compute payables in days. The company can use supplies for production operations without paying for them that many days. ((Opening Payables + Closing Payables)/2) / Daily Production
Cash Conversion Cycle's (CCC's) Significance
Shorter cash conversion cycle can lead to a comfortable cash position, and vice versa. For example, if you extend several months' credit to your customers, but get only one month's credit from your suppliers, you might soon find that you cannot pay your creditors as agreed.
The cash flow analysis using CCC also reveals in an overall manner how efficiently the company is managing its working capital. For example, good inventory management will be reflected in lower Inventory in Days, and good credit and collection management can lower Receivables in Days. Both these result in shorter CCC.
Getting longer credit terms from suppliers also leads to shorter CCC days. Good purchasing management can help a company get such credit (and also lower inventory levels through practices such as just-in-time procurement). CCC is thus a good measure of how well a company is managing its working capital.
Cash conversion cycle expresses in days how long it takes a company to convert the materials it purchases into cash. By checking how many days inventory it holds, how long it takes to collect cash from customers and also considering how many days it can take to pay suppliers, it is possible to get an idea of how comfortable a company's cash flow position is.
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