Making sense of the cash conversion cycle

A very important parameter to look at is how efficiently the company manages its working capital cycle.

Oct 14, 2018 05:10 IST India Infoline News Service

When we look at the balance sheet and income statement of a company, the focus is predominantly on items such as profitability, efficiency, leverage, and financial risk. A very important parameter to look at is how efficiently the company manages its working capital cycle. This is about the company’s liquidity and how well the working capital is managed to put least stress on other aspects of the balance sheet. A very important part of the working capital cycle is the cash conversion cycle (CCC).
 
The cash conversion cycle measures how the working capital of a company is churned efficiently for it to never run short of cash.
 
Connecting the working capital cycle and cash conversion cycle
The chart above captures the entire working capital cycle. Working capital cycle, as the name suggests, refers to the conversion of money into raw materials, raw materials into finished products, finished goods into debtors, and debtors into cash. The more efficiently the working capital cycle is managed, the less you need to draw resources from the rest of the balance sheet.
 
Working capital has two sides to it. You need to give competitive credit terms to your customers and also ensure that you collect the dues from them promptly. On the other side, you need to bargain with your suppliers for the best credit terms and pay on time to maintain a good credit standing in the market. Working capital management is all about ensuring that your short-term assets are used to fund your short-term payables. But there is no point if the working capital of your business is locked up in inventories and receivables. They are current assets in the technical sense but they cannot be converted into cash at short notice. Therefore, apart from your working capital cycle, the CCC is also extremely important to gauge the health of the business. 
 
Cash conversion cycle as a measure of working capital efficiency
The CCC is a more granular approach to working capital analysis. Here, we measure of how quickly and how efficiently you churn the debit and credit side of your working capital. The faster you churn your working capital and more efficiently you do it, the better it is for the health of the company. CCC measures how many days it takes for a company to convert resource inputs into cash flows.
 
Why is this so important?
 
The CCC attempts to measure the amount of time each net input rupee is tied up in the production and sales process before it is converted into cash through sales to customers. It calculates the lock-in period of each stage of the working capital process. The CCC effectively measures the amount of time needed to sell inventory, the time needed to collect receivables, and the length of time the company has to pay its bills without incurring penalties. The CCC is measured in number of days.
 
Calculation and interpretation of the cash conversion cycle
 
Before we measure the CCC of a company, let us for a moment go back to the complete cycle. Normally, the manufacturer buys inventory on credit resulting in accounts payable (creditors). When a company sells products on credit, it creates accounts receivable (debtors). Cash only enters the picture when the manufacturer pays the creditors and collects money from debtors. CCC measures the time between the cash outlay and the cash receipt, i.e., the outflow of cash and the inflow of cash.
 
Mathematically, the CCC can be expressed as follows:
CCC = DIO + DSO - DPO

In the above formula “Days Inventory Outstanding (DIO)” refers to the number of days it takes to sell an entire inventory. A lower DIO means the company is monetizing its inventories faster.
 
“Days Sales Outstanding (DSO)” is the number of days to collect on an average from debtors. The lower the DSO, the better as it means that the company gives shorter credit to its debtors.
 
“Days Payable Outstanding (DPO)” refers to the average number of days it takes to pay off creditors. The higher the DPO, the longer the company holds cash.
 
Normally, DPO and DSO are determined by the size and bargaining power of the company in the industry and the nature of the industry. The DIO is a function of the inventory turnaround time. CCC basically calculates the effectiveness of a company's working capital management.
 
A low CCC signifies a well-managed company, and thus can be used to help evaluate potential investments. However, CCC cannot be seen in isolation and must be juxtaposed with other fundamentals, such as the return on equity (ROE) and return on assets (ROA), Asset turnover ratios, and return on capital employed (ROCE).
 
Amazon and the story of negative CCC
 
Let us get back to the formula of CCC (DIO + DSO – DPO). If it takes 20 days to unstock the inventory, 30 days to receive funds from debtors and 25 days to pay to creditors, then you have a CCC of 25 (20+30-25) days. Of course, this means nothing in isolation and needs to be seen as a time-series trend and also with reference to industry benchmarks. CCC is normally positive, but can it also be negative? Actually, online giant Amazon has a negative CCC.
 
As per Forbes’ calculation in 2012, Amazon held inventory for 29 days and took 11 days to collect receivables, but paid its creditors after 54 days. This resulted in a negative CCC for Amazon.com of (-14 days). This possibly explains why the stock is quoting at close to a trillion dollars in market cap, despite little to show by way of profits. This is how important CCC can be to your business.

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