Cash conversion cycle is one of the important tools in hands of users of financial statements including investors to measure liquidity performance of the business and ultimately it will also reflect how good the entity is being managed with its resources especially in short-term.
Cash is life line of every kind of business. Without cash no numbers really matter and nothing else can really continue for long. Just to understand how important cash is you can think of business reporting large amount of profits at the year end in the income statement but not able to distribute same profits among shareholders because of low cash or liquidity. If your profits cannot be converted into dividends then investors won’t be happy by just having profits in the financial statements. Entity needs to convert profits into dividends and for that it needs cash and to have enough cash so that it can pay dividends and also its liabilities in time management, especially finance manager, needs to keep cash inflows and outflows in check.
Cash conversion cycle is a simple analysis between cash inflows and outflows. We all understand every business pays for the products and services bought and receives for the products and services sold. In layman terms slower the cycle of inflows and outflows slower will be entity’s growth i.e. if entity is taking too long get inflows and making outflows of cash growth will be slow. On the other other hand if the cycle is fast i.e. entity can quickly generate cash i.e. cash inflows and is also able to quickly pay the liabilities than business can grow at better pace. Let’s understand how pace of cash inflows and outflows affect business.
Cash conversion cycle (CCC) is calculated as follows:
CCC = Days to inflows – Days to outflows
Keeping things simple cash inflows are mostly generated by selling products and services to customers and outflows happen to make the payments to creditors. Now it is every entity’s dream that it should be able to quickly receive cash from its customers and delay the payment to creditors as long as it is possible. But WHY?
With quick receipt from customers and not paying for long to creditors entity can maintain a reasonable pool of cash and having large amounts of cash is always a good thing as entity can make investments. Larger the amount of cash more the possibilities of making investment and that simply means business growth. In simple words these are all tactics to maintain enough cash so that entity can cater short term payments towards liabilities, can make investments and even able to respond to unexpected losses.
So every finance manager eyes for every possibility to shorten inflows time and lengthen outflows of cash. But lets see what constitutes inflows and outflows.
Cash is generated (cash inflow) by selling goods. But to sell goods you need to buy raw material. So simply the time you take to convert raw materials into cash is the time you take to generate cash inflows. But following is how it happens in detail:
- To be able to sell goods you need raw material and for that you place order and it takes time to receive raw material from the supplier i.e. ordering period
- Next you require time to convert raw materials into finished goods i.e. conversion time or simply production period.
- In some cases finished goods does not necessarily mean saleable goods. You need to simply wait until your finished goods gets in saleable condition. For example you might have to move the goods from warehouse to store (market, retailer etc). I am calling it transition period i.e. when goods are in transition from being finished to saleable.
- Even if goods are ready to be sold they will not be immediately bought by customer so time they remain on shelf i.e. “shelf time” or shelf period. Don’t confuse it with shelf-life. Organisations usually do advertisements, offer discounts, place goods at prime locations in stores, directional lights, floor patters, signals are just one way to attract customers to reduce the time goods remain on shelf unsold.
- Once the goods are sold every entity wants to have cash immediately but that happens in least cases. Majority of the sales are on credit terms and the time customers take to make the payment also gets counted i.e. receivables period.
This is not the exhaustive list of the factors than lengthen or adds up to inflow period. So anything or any reason that causes delayed inflows will be added up with the above mentioned periods to get the correct length of inflows period in days or months etc.
Total days related to inflows i.e. total time required to generate inflows can be calculated as follows:
Ordering period + Conversion period + Transition period + Shelf period + Receivables period
Now remember the formula other element in the cash conversion cycle or CCC formula is the days to outflows i.e. the time by which you can delay the payment to creditors and they are deducted from the days inflows take. The reason we deduct this period is because longer the time creditors allow us to make the payment longer the time money will stay with us. In other words by not making the payment to creditors we hold the cash that we might have paid if creditors are not generous. That is why credit facility offered by suppliers is considered as indirect source of finance. Because the money that would outflowed towards creditors if not going out is a cash resource in the hands of business that can be utilized as per the desires of management.
So basically by delaying the payments to creditors we make up the cash deficiency that is actually caused by delayed inflows. That is the reason why every entity is happy to have payment period longer then receivables period. Now lets analyse the CCC formula.
CCC = Time to inflows – Time to outflows
The results of this formula can either of the following three:
Each of these three results have impact on the business’ ability perform well in terms of liquidity and profitability. But before we even generalize whether positive, zero or negative cash conversion period is good for entity we need to look at several factors and understand why we have such results. Following discussion will explain the pros and cons of positive or negative cash conversion cycle.
Positive cash cycle
Positive cash cycle means at current state of operations entity is taking more time to generate cash as compared to time required to make payments. Positive cash cycle does not necessarily a result of increasing conversion time or delayed payments from customers it may be because creditors are now asking for quick payments
- Easy terms of payments i.e. more time for customers to pay that will push the sales revenue increase market share by getting to more customers.
- Gaining trust of creditors and thus easy access to most of suppliers due to short payables period
- Increase in working capital requirement i.e. more stock required to support increased sales that may tie up additional cash and thus have to manage short term loans to make up short term liabilities and for that interest charges will increase
- Increased risk of bad debts
- Risk of unfulfilled orders
- Making payments to creditors even if money is not yet received from customers
Negative Cash cycle
Negative cash cycle is complete opposite of the above situation. However its repercussions are somewhat different that can be understood by going through pros and cons of negative cash cycle.
- Indirect source of financing from creditors and thus decrease in the requirement of arranging short term loans and that will cut cost of capital and push the overall profitability and gearing of the business.
- More prospects of making investments due to availability of free cash
- Not paying creditors until customers pay.
- Unsatisfied creditors
- Loss of revenue
- Loss of market share
- Deprive entity from growing in new markets as receivables period is short and payment period is long. Customers won’t be happy as they do not have facility of reasonable credit term and creditors won’t trust because of long payment time.
Zero or Equal cash cycle
In this case the time inflows take to occur is equal to the time when outflows occur. In this case we may experience mix of pros and cons of negative and positive cash flows. It is hardly the case in reality as most of the time we either have positive or negative cash cycle.