Introduction
Cash Conversion Cycle refers to the period of time that a company may take to convert its resources into cash. It measures the efficiency of the working capital utilization. The major role of the management team in most cases is to manage the working capital. The formula for calculating the Cash Conversion Circle (CCC) is equal to DSO+DIO-DPO. CCC literally measures the liquidity status of the company and the risks that are associated with the expansion and growth of the company. A company may also decide to shorten its CCC in order to reduce risks but other risks are again created in the process as the company can achieve a negative Cash Conversion Cycle by invoicing and collecting payments from customers before the payment of suppliers. But the policy of collecting cash with strict deadlines from clients but making lax payments to suppliers is basically unsustainable and fair (Paramasivan & Subramanian, 2009).
The formula; Cash Conversion Cycle = DSO + DIO – DPO, DIO refers to Days Inventory Outstanding while DPO stands for Days Payable Outstanding and DSO refers to Days Sales Outstanding (Myers & Allen, 2011).
The details for CCC calculations are derived mostly from the Company’s balance sheet, income and expenditures accounts but not from a Company’s Cash Flow which has insufficient information largely because Cash Flow is particularly affected by investments and financing operations or activities. The above formula is based on the operations of a retailer whose business operations involves reselling of purchased goods while paying the suppliers and also collecting cash payments from debtors.
The aim of calculating the CCC is to weigh the options of changing the payment terms and policies that a company has engaged to regulate its credit terms pertaining to sales on credit. The Cash Conversion Cycle can determine the outcome of payment terms that are applicable to debtors and the sales on credit terms.
Cash Conversion Cycle = DSO + DIO – DPO
| Part I | |||
| Particulars | Details of the Formula | Turnover | Conversion |
| Days Inventory Outstanding | 365/Inventory Turnover Ratio | 4.67 | 78.21 |
| Days Sales Outstanding | 365/Receivables Turnover Ratio | 10.00 | 36.50 |
| Days Payables Outstanding | 365/Payables Turnover Ratio | 7.00 | 52.14 |
| Cash Conversion Cycle | DSO+DIO – DPO | 62.57 |
The firm’s CCC is 62.57
It means that the organization takes about 62.57 days to convert the total amount invested in inventory to generate revenue (Berk & DeMarzo, 2011).
Depending on the performance of the industry and the company’s policy on debt collection and the average collection period that the company applies, the company may decide to increase or reduce the CCC. On average the shorter the CCC the better for the company but if it’s too short then the company may be applying a rigid stand to its debtors and it may be preventing them from utilizing all their sales potential hence denying the company some revenues. On the other hand if the conversion period is too long then the company may be tying a lot of capital instead of circulating it to make maximum profits
| Part II | |||
| Details | Particulars | Turnover | conversion |
| Payables deferral period | 40 days | 40 | 9.13 |
| Inventory Conversion period | 62 days | 62.00 | |
| Average collection period | 29 days | 29 | 12.59 |
| Cash Conversion Cycle | DSO+DIO – DPO | 65.46 |
- The company’s conversion period is 65.46
It means that the organization takes about 65.46 days to convert the total amount invested in inventory to generate revenue (Berk & DeMarzo, 2011).
2
| Sales | 4 million | |
| Turnover | Turnover | 29 |
| Accounts receivable | 266,667.20 | |
| Collection period | Accounts receivable/(total sales/365) | |
| 29 days = x/4m/365 | 4000,000/365 | 9195.402299 |
| x | 9195.42 X 29 | |
| 29 X 9195 | 266667.18 |
| $millions | |
| Revenue | 20 |
| Cost of Goods 70% of sales | 14 |
| Inventory | 3 |
| Receivables | 2 |
| Payables | 2 |
| Receivable turnover | ||
| Sales | 4 million | |
| Collection period | 29 | |
| Accounts receivable | 266,667.20 | |
| receivable Turnover | sales/accounts receivable | 15.0 |
3.
Receivable turnover =
Sales/accounts receivable
4,000,000/266,667.2
= 15
Finally to conclude, CCC is mostly applied to evaluate the debtor’s payment terms and their profitability to the company. It can also reveal if the payment terms are too stringent to the debtors and also if there is any need to increase or reduce the payment periods. Cash Conversion Circle is a reliable tool for evaluating how a company’s operations are being managed. The aim of calculating the CCC is to weigh the options of changing the payment terms and policies that a company has engaged to regulate its credit terms pertaining to sales on credit. The Cash Conversion Cycle can determine the outcome of payment terms that are applicable to debtors and the sales on credit terms. A firm may influence its rates of turnover by shorten its cash conversion circle in order to reduce risks but other risks are again created in the process as the company can achieve a negative Cash Conversion Cycle by invoicing and collecting payments from customers before the payment of suppliers. It’s widely used to analyze the performance of a company’s credit system. It provides the required information that can lead to a change in the company’s policy.
References
Berk, J. & DeMarzo, P. (2011) Corporate Finance (Second ed.), Boston, MA: Prentice Hall, pp. 966–969
Myers, R.A & Allen, F. (2011) Principles of Corporate Finance (Tenth ed.) NY: McGraw-Hill Irwin, pp. 50–53
Paramasivan, C. & Subramanian, T. (2009). Financial management, NY: New Age International. pg 47.
