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9 Secrets About Cash Conversion Cycle

Cash Conversion Cycle


This liquidity metric expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable. Remember to subscribe for free stock fundamental analysis tutorial here.

The cash conversion cycle (CCC) measures the number of days a company’s cash is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter this cycle, the more liquid the company’s working capital position is. The CCC is also known as the “cash” or “operating” cycle.

DIO is computed by

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
2. Calculating the average inventory figure by adding the year’s beginning (previous yearend
amount) and ending inventory figure (both are in the balance sheet) and dividing by 2
to obtain an average amount of inventory for any given year; and
3. Dividing the average inventory figure by the cost of sales per day figure.

For XYZ FY 2010 (in Rs. Crores), its DIO would be computed with these figures:

Cost of Sales per day= 13771/365=37.73
Average Inventory= (0+0)/2=0
Days Inventory Outstanding= 0/37.73=0

DIO gives a measure of the number of days it takes for the company’s inventory to turn over, i.e., to be converted to sales, either as cash or accounts receivable. Understandably, being an IT company, DIO for XYZ comes out to be zero.

DSO is computed by

1. Dividing net sales (income statement) by 365 to get a net sales per day figure;
2. Calculating the average accounts receivable figure by adding the year’s beginning (previous yearend amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable
for any given year; and
3. Dividing the average accounts receivable figure by the net sales per day figure.
For XYZ FY 2010 (in Rs. crores), its DSO would be computed with these figures:

Net Sales per day
= 21140/365=57.92
Average Accounts receivables
= (3390+3244)/2=3317
Days Sales Outstanding
= 3317/57.92=57.27

DSO gives a measure of the number of days it takes a company to collect on sales that go into accounts receivables (credit purchases).

DPO is computed by

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day
figure;
2. Calculating the average accounts payable figure by adding the year’s beginning (previous
yearend amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and
3. Dividing the average accounts payable figure by the cost of sales per day figure.

For XYZ FY 2010 (in Rs. crores), its DPO would be computed with these figures:


Cost of Sales per day
= 13771/365=37.73
Average Payables
= (1544+1995)/2=1769.5
Days Payable Outstanding
= 1769.5/37.73=46.90

DPO gives a measure of how long it takes the company to pay its obligations to suppliers.

CCC computed:

Net Sales per day= 21140/365=57.92
Average Accounts receivables= (3390+3244)/2=3317
Days Sales Outstanding= 3317/57.92=57.27
Cost of Sales per day= 13771/365=37.73
Average Payables= (1544+1995)/2=1769.5
Days Payable Outstanding= 1769.5/37.73=46.90

XYZ’S cash conversion cycle for FY 2005 would be computed with these numbers (rounded):

DIO
0
DSO
57
DPO
47
CCC
10

Often the components of the cash conversion cycle - DIO, DSO and DPO – are expressed in terms of turnover as a times (x) factor. For example, in the case of XYZ, its days debtors outstanding of 57 days would be expressed as turning over 6.4x annually (365 days ÷ 57 days = 6.4 times). However, actually counting days is more literal and easier to understand when considering how fast assets turn into cash.

An often-overlooked metric, the cash conversion cycle is vital for two reasons. First, it’s an indicator of the company’s efficiency in managing its important working capital assets; second, it provides a clear view of a company’s ability to pay off its current liabilities.

It does this by looking at how quickly the company turns its inventory into sales, and its sales into cash, which is then used to pay its suppliers for goods and services. Again, while the quick and current ratios are more often mentioned in financial reporting, investors would be well advised to measure true liquidity by paying attention to a company’s cash conversion cycle.

The longer the duration of inventory on hand and of the collection of receivables, coupled with a shorter duration for payments to a company’s suppliers, means that cash is being tied up in inventory and receivables and used more quickly in paying off trade payables. If this circumstance becomes a trend, it will reduce, or squeeze, a company’s cash availabilities. Conversely, a positive trend in the cash conversion cycle will add to a company’s liquidity.

By tracking the individual components of the CCC (as well as the CCC as a whole), an investor is able to discern positive and negative trends in a company’s all-important working capital assets and liabilities. For example, an increasing trend in DIO could mean decreasing demand for a company’s products. Decreasing DSO could indicate an increasingly competitive product, which allows a company to tighten its buyers’ payment terms. As a whole, a shorter CCC means greater liquidity, which translates into less of a need to borrow, more opportunity to realize price discounts with cash purchases for raw materials, and an increased capacity to fund the expansion of the business into new product lines and markets. Conversely, a longer CCC increases a company’s cash needs and negates all the positive liquidity qualities just mentioned.

Current Ratio Vs. The CCC

The obvious limitations of the current ratio as an indicator of true liquidity clearly establish a strong case for greater recognition, and use, of the cash conversion cycle in any analysis of a company’s working capital position.

Cash Conversion cycle for XYZ over five years :

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In

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An award is something which is awarded based on Merit. Awards & Recognition are a must in Life as it provides the necessary vigour to keep progressing ahead in Life. Awards do not only acknowledge success; they recognise many other qualities: ability, struggle, effort and, above all, excellence. This is the reason that for past 22 Years we have been christined as Best Stock Market Tips Provider & we are at the 'Top' in this field. Check out our Awards by clicking on Image or Post Title Now!!

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Chart> Nifty A B C D E F G H I J K L M N O P Q R S T U V W X Y Z 0-9