CASH CONVERSION CYCLE
The
factors used to derive the cash conversion cycle are as follows:
- The average time required to pay supplier invoices
- The average time required to convert raw materials into finished goods
- The average time required to collect receivables from customers
The
resulting cash conversion cycle formula is:
Days
inventory outstanding + Days sales outstanding - Days payables outstanding
Of
these elements of the cycle, the one most amenable to significant change is the
days of inventory outstanding. Receivables figures tend to vary little, while
payables payment terms are dictated by existing contracts with suppliers.
Consequently, an astute management team will focus its attention on shrinking
the investment in inventory.
The
cash conversion cycle is typically used as part of an analysis of how the
investment in working capital can be reduced. This can result in a number of
operational and policy decisions, such as:
- Outsource production, to avoid an investment in inventory
- Install a just-in-time production system, to reduced the inventory investment
- Cancel poorly selling products, thereby eliminating the associated amount of supporting inventory
- Lengthen delivery times, so that the amount of finished goods kept on hand can be reduced
- Tighten the credit policy, to reduce billings to customers less likely to pay on time
- Alter the collection procedures to enforce more rapid customer contacts regarding overdue accounts
- Negotiate with suppliers to lengthen payment terms
A
short conversion cycle is considered highly desirable, since it means that a
business can be operated with a reduced amount of cash. A company with a
shorter conversion cycle than its peer group probably has reached this point
due to a continual review of the entire process over a long period of time. At
a minimum, a responsible manager may want to track the conversion cycle on a
trend line, and take action whenever the cycle indicates that it is taking
longer to convert invested funds back into cash.
The
cycle is also closely monitored in smaller organizations that have minimal
amounts of equity or debt funding. These businesses have so little excess cash
that they must be mindful of how their cash is being used. This is a particular
problem for nonprofit entities, since they usually have small cash reserves.
SOURCE BY: ACCOUNTING TOOLS(R)
