Article 1- Cash Conversion Cycle – Lee Chandler

6In this article I will give a brief overview of the Cash Conversion Cycle (CCC).  First we will cover the formula and how to interpret the products. Next I will talk about some of the advantages and disadvantages of using the ratio to compare businesses.

 

Cash Conversion Cycle(CCC) = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding

 

Days Inventory Outstanding(DIO) = average inventory / cost of goods sold * 365

 

Days Sales Outstanding(DSO) = average accounts receivable / revenue per day

 

Days Payables Outstanding(DPO) = average accounts payable / cost of goods sold per day

 

First we will discuss the formulas. The three bottom formulas give you the inputs needed for the CCC.  DIO gives you an average estimate of how long each piece of inventory will be kept before it is sold.  DSO tells you the average time it takes for the customers to pay for goods bought on credit.  DPO gives you an idea of how long on average you get to keep the money from a sale before you need to pay your supplier. The inputs to the formula should never be negative but the product can be. To demonstrate I will use some old data for the Apple Inc. .  Apple keeps its inventory for about 6 days before it is sold to customers.  It takes the customers about 50 days to pay for the goods they have purchased.  Lastly, Apple pays their suppliers about 101 days after the point of sale. So the formula would be CCC = 6 + 50 – 101 giving Apple a CCC of negative 44 days.  Since Apple does not need to pay the suppliers immediately they retain the use of the funds owed and can put them to use in other areas before they must pay their debts.

The Cash Conversion Cycle and its components give us a rough idea of how effective the company is at selling its products, collecting payment, and negotiating favorable terms with their suppliers.  When comparing two firms of similar size and industry the CCC can show if a firm has room for improvement.  If the company holds inventory longer than its competitor then it may need to improve sales to remain competitive or simply produce less to save on storage fees.  If the company takes too long to collect then they are missing out on the use of funds that are owed to them.  Similarly if a firm finds that the competition has more favorable terms with their suppliers then they may be wise to renegotiate. 

The cash conversion cycle ratio does have some vulnerabilities.  CCC should only be used to compare companies within the same industry and of similar size to prevent different environmental factors from distorting the comparison.  For instance a large firm like Apple can negotiate more favorable terms with their suppliers because their large regular orders provide stability for the supplier.  It would be unreasonable to hold a small firm to the same standard when they could rarely get such a beneficial agreement.  The formula also does not account for cash sales so the form of income for a company may give a false interpretation.  A change of inventory valuation method can also cause discrepancies during the transition period.

Lastly it is important to note that a negative ratio may not always be beneficial.  A low DIO may indicate a higher risk of stockout and lost sales for the firm.  A short DSO may drive away potential customers if they desire more favorable payment terms offered by the competition.  Lastly a long DPO may require more costly payment terms with the supplier or may even show an inability for the firm to pay its debts on time.  I hope you found this article helpful and thank you for your time.

By. 

Marcus A. Baker

https://www.linkedin.com/in/marcus-baker-64736173/

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