Cash conversion cycle

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The Cash Conversion Cycle (CCC) measures how long an investment with suppliers deprives a firm of cash -- it is (in the generic case of a retailer) the time between disbursement for inventory and collection on its sale. Thus, the CCC measures how risky it would be to increase this investment with suppliers in the course of expanding customer sales. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.

Contents

Basic equation

CCC (in days) = Inventory conversion period + Receivables conversion period – Payables conversion period

where terms are defined as:

Payables conversion period 
days holding accounts payable until it's all paid in cash (i.e. time before inventory growth hits cash),
Inventory conversion period 
days holding inventory until it's all sold
Receivables conversion period 
days holding receivables until the last cash collection

and computed with following formulas:

Payables conversion period = Avg. Accounts Payable
inventory growth + COGS		 × 365


Inventory conversion period = Avg. Inventory
COGS		 × 365


Receivables conversion period = Avg. Accounts Receivable
Sales		 × 365

Derivation

1. Sales operations affect four balance sheet accounts

The generic equation assumes a retailer, whose cash-generating operations can be summarized by four steps: its suppliers deliver the inventory that its customers then acquire, and both transactions are at some point paid off account. These four aspects of cash-generating operations affect four balance sheet accounts (in pairs): "payables," "inventory," "receivables," and "cash". First, the firm owes cash when its suppliers deliver inventory ("accounts payable" and "inventory" grow), and then is owed cash when customers acquire this inventory ("accounts receivable" grows by the amount the firm accrues in "revenue"; "inventory" fully subsides in exchange for "cost of goods sold" or COGS expense). Eventually, the firm disburses cash to the suppliers ("accounts payable" fully subsides; "cash" leaves) and collects cash from its customers ("accounts receivable" fully subsides; "cash" enters).

2. Calculate the CCC from the durations of three of these four accounts

While cash has other influences, we have assumed that the three noncash accounts have no influences other than these cash-producing operations. Under this assumption, we could calculate the CCC if we knew how long a firm is holding these accounts on its books: Starting from the firm's "operating cycle" (the sum of the periods that "inventory" and then "receivables" is held on the books), we subtract the time that "payables" is held to reflect the fact that cash was not disbursed when the inventory was acquired, but only when accounts payable (which was added when the inventory was acquired) is removed from the books:

CCC (in days) = Inventory conversion period + Receivables conversion period – Payables conversion period

  • "Payables conversion period" (or "Days payables outstanding") refers to the time "accounts payable" is held (from inventory delivery until cash disbursal).
  • "Inventory conversion period" (or "Days inventory outstanding") refers to the time inventory is held (beginning at the same moment as the "payables conversion period," i.e. the inventory delivery, and ending with its sale for a receivable).
  • "Receivables conversion period" (or "Days sales outstanding") refers to how long inventory is held (from the end of the "inventory conversion period," i.e. the sale of inventory, until cash collection).

3. Calculate these three durations using their balance sheet levels and two income statement accounts

To calculate these three intervals, there are two helpful income statement accounts: COGS and revenue. This is because Accounts Receivable grows only when revenue is accrued; and Inventory shrinks and Accounts Payable grows by an amount equal to the COGS expense (in the long run, since COGS actually accrues sometime after the inventory delivery, when the customers acquire it).

Then, we use the equation TIME =LEVEL/RATE -- i.e. each interval roughly equals the TIME needed for its LEVEL to be achieved at its corresponding RATE. We estimate a LEVEL across the period, as its average from the balance-sheets surrounding the period; we estimate its RATE for the period as the corresponding income-statement item.

  • Payables conversion period = the TIME needed to reach the period-average LEVEL of payables, at its corresponding (daily) RATE -- this rate being [inventory increase + COGS], since these are the items for the period that can increase "trade accounts payables," i.e. the ones that grew its inventory.
NOTICE that we make an exception when calculating this interval: although we use a period average for the LEVEL of inventory, we also consider any increase in inventory as contributing to its RATE of change. This is because the purpose of the CCC is to measure the effects of inventory growth on cash outlays. If inventory grew during the period, we want to know about it.
  • Inventory conversion period = the TIME needed to reach the period-average LEVEL of inventory, at its corresponding (daily) RATE -- this rate being COGS, since this is the item that (eventually) shrinks inventory.
  • Receivables conversion period = the TIME needed to reach the period-average LEVEL of receivables, at its corresponding (daily) RATE -- this rate being revenue, since this is the item that can grow receivables (sales).

See also

External links

Retrieved from "http://en.wikipedia.org/wiki/Cash_conversion_cycle"

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