Study: Compute and Understand the Cash Conversion Cycle
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Slides 1-3 (0m:53s)
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Welcome to Introduction to Accounting Preparing for a User's Perspective
Compute and Understand the Cash Conversion Cycle
What does the cash conversion cycle mean (aka net operating cycle)?
The cash conversion cycle
Links to an external site. attempts to show how long the company's cash is tied up in inventory and in accounts receivable.
When a company's cash is not tied up in inventory or receivables the company can use it for other purposes such as paying dividends, buying back stock, expanding operations, paying off debt, and borrowing less. By using the freed up cash to pay off debt and to reduce borrowings the company's finance costs will decrease and its Net Income will increase.
In general, wise management constantly strives to reduce its cash conversion cycle and thereby free up cash and reduce financing costs.
Slides 4-5 (1m:01s)
Links to an external site.How do you compute the cash conversion cycle?
The cash conversion cycle is computed by taking the company's operating cycle and deducting from it its days payables outstanding.
The days payables outstanding figure represents the number of days between when a company purchases inventory and when it pays off the related accounts payable. Assuming you are computing it for a full year, days payables outstanding is computed as follows:
Note: Sometimes companies' will refer to Cost of Goods Sold as Cost of Sales or Cost of Revenues.
When companies increase their days payables outstanding their cash conversion cycle decreases and they are able to keep their cash longer and use it for other purposes.
Review: If you don't recall how to compute the operating cycle, or its components, you can review the diagram below and if it still doesn't come back to you, you might want to review the video titled "Compute and Understand the Operating Cycle - Slides 1-14" as provided in Canvas and in YouTube.
Slide 6 (0m:45s)
Links to an external site.Example: Two virtually identical companies (Company A and Company B) have days sales in inventory of 30 and days sales in receivables of 25. However, their days payables outstanding are 10 and 50, respectively. Compute both companies' cash conversion cycles:
Company A: Days sales in inventory 30 + Days sales in receivables 25 - Days payables outstanding 10 = 45 days
Company B: Days sales in inventory 30 + Days sales in receivables 25 - Days payables outstanding 50 = 5 days
Based on the above, Company B's shorter cash conversion cycle provides it 40 more days worth of cash than Company A.
Some companies are very good at minimizing their cash conversion cycles by having great inventory management, great credit granting and collecting, and great supplier relationships which allow them to significantly delay their payments on accounts payable.
Slide 7 (1m:57s)
Links to an external site.Example: Amazon's cash conversion cycle for the year ended 12/31/12 was a negative 41.04 days computed as follows:
Days sales in inventory 43.76 + Days sales in receivables 20.94 - Days payables outstanding 105.74 =
Cash conversion cycle = -41.04
If you are interested in knowing how each of these variables were computed, here they are below. Days sales in inventory, days sales in receivables, and days payables outstanding. Please stop the video and review these computations based on what you learned from the operating cycle video and from this topic regarding the days payables outstanding to ensure you understand where the numbers are coming from:
1) Days sales in inventory: (365 / (Cost of sales $45,971 M / Average inventory $5,511.5 M) = 43.76
Average inventory: (Beginning inventory $4,992 M + Ending inventory $6,031 M) / 2 = $5,511.5 M
2) Days sales in receivables: (365 / (Net product sales $51,733 M / Average receivables $2,967.5 M) = 20.94
Average receivables: (Beginning receivables $2,571 M + Ending receivables $3,364 M) / 2 = $2,967.5 M
3) Days payables outstanding: Ending Accounts Payable $13,318 / Cost of Sales $45,971 M) * 365
What I want to do is point out a few very interesting things about Amazon's cash conversion cycle. Amazon's days payables outstanding of 105.74 indicates that on average Amazon makes its suppliers wait over 100 days to get paid. Amazon
Links to an external site. clearly has very good credit terms with its suppliers. In fact, because Amazon's days payables outstanding is so long, it's cash conversion cycle has become so short that it is actually a negative 41.04 days. Amazon's negative cash conversion cycle effectively means that Amazon does not have to borrow any money to purchase inventory because it receives customer payments in advance of when it has to pay its suppliers. Amazon effectively funds all of its inventory purchases on the backs of its suppliers who provide it interest-free credit for 105.74 days. In addition, due to Amazon's negative cash conversion cycle, it has an extra 41.04 days to use billions of dollars of interest-free cash for other things, cash that would have normally been tied up in inventory or in receivables.
Slide 8 (0m:57s)
Links to an external site.In the operating cycle video we discussed how, in general, companies benefit by minimizing their operating cycle through the reduction of their days sales in inventory and days sales in receivables. However, we also noted that an operating cycle that is too short can have unintended consequences such as lost sales and disgruntled customers. Similarly, companies should strive to reduce their cash conversion cycles, which might require increasing their days payables outstanding. However, companies need to avoid the unintended consequences of taking too long to pay off suppliers. For example, suppliers who do not get paid on time as agreed may simply choose to stop selling to the company, or choose to tighten up their credit policies, or worse yet, choose to require Cash On Delivery (i.e. COD) for all purchases. In short, as management strives to reduce its cash conversion cycle it needs to ensure that the benefits of a shorter cycle outweigh the related costs.
Slides 9-10 (1m:31s)
Links to an external site.How do users use the cash conversion cycle to analyze a company's cash management?
Many financial statement users watch for trends in a company's cash conversion cycle as they relate to other amounts and ratios such as the gross margin and gross margin %. What would you think about a company whose cash conversion cycle is declining and its gross margin and gross margin % is declining? This may be an indication that the company has lost its market position and its pricing power and is having to heavily discount its products to get them sold, which may not be sustainable in the long-term. However, if its cash conversion cycle declines and its gross margin and gross margin % both increase, this would normally be a sign that the market for the company's products is improving and that it is managing its inventory, credit, collections and payables efficiently and effectively.
Some companies study their potential customers' cash conversion cycles to determine what if any credit to grant to them and what their payment terms should be. For example, if Company B were to request credit from Company A, 30 days same as cash, Company A would most likely request Company B's audited financial statements so it could evaluate Company B's credit-worthiness. Company A might then choose to compute Company B's cash conversion cycle as well as its days payables outstanding. If Company B only has 5 days payables outstanding, Company A might be wise to require cash on delivery (COD) or require payment within only 5 days.
Slide 11 (0m:25s)
Links to an external site.A short, or negative, cash conversion cycle can:
1) reduce financing costs because less cash will be stuck in inventory and/or receivables
2) expand more aggressively because it will have freed-up more cash that it can use
3) reduce inventory carrying costs because it will be able to store less inventory (think of the just-in-time inventory systems)
4) reduce the risk of customer non-payments because more customers will pay before their accounts become uncollectible
Slides 12-13 (0m:33s)
Links to an external site.Please take a moment and study the following diagram which should help summarize the cash conversion cycle for you.
By now you should be able to define, compute and interpret:
the operating cycle
the net operating cycle, also known as the cash conversion cycle
the days payables outstanding
Solve for unknown variables in the cash conversion cycle.
Good luck on the quiz.