Main menu

Cash Conversion Cycle

Cash Conversion Cycle (Net Trade Cycle) – a measurement of the company’s working capital efficiency reflecting the number of days needed by a company for revenue generation from its assets. In other words, it's a period, during which the company's current assets make one full turn. The indicator can be computed by excluding the company's days payable outstanding from its operating cycle.

Positive for a company is a declining trend of the cash conversion cycle, indicating the decrease of time needed for money to be converted from cash to inventories, then to goods and services and back to cash. In other words, the overall activity of a company increases. It is reasonable to compare the value of this indicator with main competitors. Despite the decline of the value is a good trend for the company, negative values of this indicator give the analyst a warning sign that the company is lacking funds for covering its liabilities to creditors, when due. This means that the firm's accounts payable exceed normative amount, and this may cause a negative long-term effect on the company's liquidity.

Resolving the problems with the current ratio exceeding the normative range:

In case the indicator value is lower than zero, it is necessary to take some measures for the company's liquidity improvement, for example, to involve some additional funds through long-term loans. If the value is too high, a complex of actions should be realized, which would allow to:

Formula(s):

Cash Conversion Cycle = Inventory Conversion Period + Receivables Conversion Period - Payables Conversion Period

Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding

Cash Conversion Cycle = (Average Inventory ÷ (Cost of Goods Sold ÷ 360)) + (Accounts Receivable ÷ (Net Sales÷ 360)) – (Accounts payable ÷ (Cost of Goods Sold ÷ 360))

Example:

Cash Conversion Cycle (Year 1) = (314 ÷ (3067 ÷ 360)) + (266 ÷ (3351 ÷ 360)) – (112 ÷ (3067 ÷ 360)) = 36,8 + 28,5 – 13,1 = 52,2

Cash Conversion Cycle (Year 2) = (428 ÷ (3207 ÷ 360)) + (325 ÷ (3854 ÷ 360)) – (356 ÷ (3207 ÷ 360)) = 48,0 + 30,3 – 39,9= 38,4

Cash conversion cycle was 52,2 days in year 1, meaning that the company needed 52,2 days to convert cash into inventory, then into goods and services, and then through sales back into cash. In year 2 company’s cash conversion cycle has declined to 38,4 days, indicating that the company most likely has become more effective in term of its operations. However, to get more full information on its position, this indicator analysis should be combined with some other ratios, such as return on equity and return on assets.

Conclusion:

Cash Conversion Cycle reflects the period, needed by financial resources of a company to pass all stages of conversion from cash through inventories and goods and services back to cash. The closer to zero cash conversion cycle value is, the more efficient company's operations are. This means that the company is becoming faster with collecting its accounts receivable and moving its inventory, at the same time taking as long with paying its account payable, as it is possible (but not missing the due date). Negative values are not desirable, as they indicate problems with meeting the company's obligations in time.

Add comment


Security code
Refresh