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Importance of understanding Cash Conversion Cycle to estimate Working Capital Requirements

What does cash conversion cycle imply?

Cash conversion cycle, also known as net operating cycle or working capital cycle, indicates the length of time between a company’s payment for raw materials, entry into stock, storage into the warehouse, and receipt of cash from the ultimate sales of finished goods. In simple terms, a cash conversion cycle is a measure of operational effectiveness and depicts the time taken by a company to covert its investment in inventory and other inputs into an inflow of cash. It is determined by adding the number of days required for each stage in the cycle. In order to comprehend it more clearly, let us take an example. Suppose a business firm holds raw materials for an average period for 60 days, it obtains credit from the supplier of materials for an average period of 15 days, the production process takes 15 days on an average, finished goods are held for 30 days in the process, and 30 days average credit is extended to the debtors. Thus, the total time that it takes for the firm to realize cash from its operating activities comes out to 120 days, i.e., 60 – 15 + 15 + 30 + 30 days. This is represented by the working capital cycle. In the form of an equation, the cash conversion cycle process can be expressed as follows:

Cash Conversion Cycle = R + W + F + D – C, where

R = Raw material storage period

W = Work-in-progress holding period

F = Finished goods storage period

D = Receivables (Debtors) collection period

C = Credit period allowed by suppliers (Creditors)

This cash conversion cycle is expressed below with the help of a diagram:

Usefulness of cash conversion cycle

Net operating cycle is a useful tool for managing working capital in a business. It is used to analyze the accounts receivable, inventory and accounts payable cycles in terms of the outstanding number of days. For instance, debtors or receivables are analyzed in terms of the average number of days it takes to collect an account from customers. Likewise, creditors are analyzed in terms of the average number of days it takes to pay a supplier invoice. Similarly, stock is analyzed by the average number of days it takes to turn over sales of a product (i.e., from the point it comes in the store to the point it is converted to cash or an account receivable).

The cash conversion cycle measures how efficiently a company’s management is handling its working capital. It shows the length of time between an entity’s purchase of inventory/materials and the receipts of cash from its accounts receivables. More precisely, it is put in practice by the management to envisage how long a company’s cash remains tied up in its operations.

The cash conversion cycle makes it easier to assess the operational efficiency of a company in managing its resources. As it is true with other cash flow computations, the shorter the cash conversion cycle, the better the business is at selling its inventories and recovering money from these sales while paying vendors.

To gain more insights, the cash conversion cycle of a company may be compared to other companies operating in the same industry and to evaluate the trend. Such measurement of a company’s cash conversion cycle to its cycles in preceding years may help with gauging as to whether its working capital management is deteriorating or improving. Moreover, a measurement of the company’s cash conversion cycle with that of its market competitors may prove helpful in determining whether the company’s cash conversion cycle is ‘normal’ relative to industry standards or not.

Interpretation of cash conversion cycle

The meaning that can be inferred from a company’s cash conversion cycle is as follows:

• Where an entity’s management takes an extended period of time to collect its outstanding accounts receivables, or has too much stock on hand or where it pays off its expenses and accounts payables too quickly, it lengthens the net operating cycle.
• A longer cash conversion cycle generally means that it takes a longer time for the company to generate cash. This can pose liquidity problems and can also mean insolvency for small companies.
• Where an entity’s management collects its outstanding payments from debtors quickly, correctly forecasts the inventory levels needed or where it pays off its bills and accounts payables slowly, it shortens the net operating cycle.
• A shorter cash conversion cycle generally means that the company is healthier. Thus, its additional money can then be used towards making any additional purchases or paying down any outstanding debt.
• When a manager has to pay its suppliers quickly with a longer cash conversion cycle, it is referred to as a pull on liquidity, which is bad for the company.
• When a manager cannot collect payments from debtors quickly enough with a longer cash conversion cycle, it is referred to as a drag on liquidity, which is also bad for the company.
• When a company’s business model results in a negative cash conversion cycle, it signifies that it is able to handle its working capital in such an effective way that, on an average, it buys stock, sells the finished product and collects the receivable even before the corresponding account payable becomes due. It is an ideal situation for the business.

How to compute Cash Conversion Cycle?

The different components of the net operating cycle process may be calculated, as shown below:

• Raw material storage period = Average stock of raw material ÷ Average Cost of Raw Material Consumption per day

This represents the average length of time within which the company keeps its raw materials in stores.

• Work-in-progress holding period = Average Work-in-progress inventory ÷ Average Cost of Production per day

This represents the average length of time within which the company processes its materials, i.e., the time gap between the issue of materials and production of the finished product.

• Finished goods storage period = Average stock of finished goods ÷ Average Cost of Goods Sold per day

This represents the length of time within which the finished products of the company remain in storage, i.e., till the time, the demand for such products materializes.

• Receivables (Debtors) collection period = Average Receivables ÷ Average Credit Sales per day

This represents the length of time within which the company is able to realize the cash generated from the sales made to its debtors on credit.

• Credit period allowed by suppliers (Creditors) = Average Payables ÷ Average Credit Purchases per day

This represents the length of time within which the company must pay off its debt obligations to suppliers of goods and materials.

The summation of all these holding periods, as reduced by credit period availed from suppliers denotes the cash conversion cycle.

Relation with working capital management and a firm’s profitability

Optimizing the net operating cycle affects the bottom-line of a company, its cash flows and the amount of external funds needed to run the business. Most of the managers solely rely on revenues and expenses to manage their cash flows; however, it is the non-optimization of cash conversion cycle that often leads to a cash crunch in the entity. If in a business, too much inventory builds up and cash lies tied up with goods which cannot be sold, it causes the business to slash prices and reduce profit margins. Similarly, if there is difficulty in collecting payments from customers, it may lead to a situation where cash is not available to re-invest in the business either in the form of investing or paying down a loan and reducing loan expenses. On the flip side, businesses can benefit from slowing down the payments to suppliers, as it allows them to make use of cash longer.

Suppose a company‘s annual sales are Rs. 100,00,000, Cost of Goods Sold (COGS) is Rs. 60,00,000, Accounts Receivables (AR) are Rs. 10,00,000, Account Payable (AP) are Rs. 9,12,000 and Inventory amounts to Rs. 8,22,000. Here,

Finished goods storage period = 8,22,000 ÷ 60,00,000/365 = 50.0 days

Receivables (Debtors) collection period = 10,00,000 ÷ 100,00,000/365 = 36.5 days

Credit period allowed by suppliers (Creditors) = 9,12,000 ÷ 60,00,000/365 = 55.5 days

(COGS is considered in lieu of credit purchases)

Cash Conversion Cycle = 50.0 + 36.5 – 55.5 = 31.0 days

In this example, cash is tied up for 31 days within the operation of the business. The longer the cash is tied up, the more money will be needed to be borrowed to run the day-to-day operation. The shorter the cash is tied up, the more the business will be able to invest back into the business.

The determination of net operating cycle or cash conversion cycle helps in the forecast, control and management of working capital needs. The length of the operating cycle is the direct indicator of the performance of a company’s management. The net operating cycle represents the time interval for which the firm has to negotiate for working capital requirements from its bankers. It enables to determine accurately the amount of working capital needed for the continuous operation of business activities.

The estimation of different components of working capital can be made on the basis of the cash conversion cycle. For instance, the funds to be invested in raw materials inventory may be estimated on the basis of the production budget, the estimated cost per unit and average holding period of raw material inventory. Say, for example, the yearly production in units is 5,000 units, the raw material cost per unit Rs. 2.50 and the raw materials are expected to remain in store for an average of 2 months before issuing to production. In this case, the raw material component in working capital requirement of the firm would be (5,000/12 × 2.50 × 2), i.e. Rs. 2,083. Similarly, other components of working capital such as debtors, finished goods inventory, trade payables, etc. can also be estimated based on their respective holding periods in the firm’s operating cycle.

The various constituents of current assets and current liabilities have a direct bearing on the estimation of working capital and the net operating cycle. The holding period of various constituents of current assets and current liabilities cycle can either contract or expand the net operating cycle period. Shorter the net operating cycle period, lower will be the requirement of working capital in a business and vice-versa.

Takeaway

Cash conversion cycle is a business metric which shows the time (expressed in terms of days) that a business firm takes to convert its investments in inventory and other resources into cash flows generated from sales. It is a great tool to determine the efficiency with which a company manages its resources. A firm prefers to see a lower value of this cycle as it is conducive to healthy working capital levels, positive cash flows, liquidity and profitability of a business.