9.3 Cash Conversion Cycle
The Cash Conversion Cycle (CCC) describes the length of time (“speed”) during which the firm pays for and collects on its working capital. (Remember: Working Capital = Current Assets minus Current Liabilities or WC = CA – CL.). We will find that the firm typically has to pay for its working capital before it collects on it. A Balance Sheet is provided below. Assume Credit Sales are $20,000,000 and Cost of Goods Sold (COGS) are $4,500,000.
Sample Company
($ Thousands)
| Cash and Equivalents | 1,000 | Accounts Payable | 400 |
| Inventories | 500 | Short-term Debt | 6,100 |
| Accounts Receivable | 2,000 | Total Current Liabilities | 6,500 |
| Total Current Assets | 3,500 | Long- Term Bonds | 3,500 |
| Property, Plant & Equip. | 9,000 | Common Stock | 1,500 |
| Other | 1,000 | Retained Earnings | 2,000 |
| Total Long-term Assets | 10,000 | Total Owners’ Equity | 3,500 |
| Total Assets | 13,500 | Total Liabilities + Equity | 13,500 |
From this information, we shall derive the Payables Payment Period, the Inventory Conversion Period, and the Average Collection Period.
| Payables Payment Period |
| The amount of time, on average, it takes the company to pay its suppliers from time of purchase. |
| PPP = (Accounts Payable ÷ COGS) (360) |
| PPP = (400 ÷ 4,500) (360) = |
| 32 Days |
| Inventory Conversion Period | Average Collection Period |
| ICP is the span of time it takes, on average, to convert raw materials into finished goods and sell it. | ACP is the amount of time it takes, on average, to collect accounts receivable from time of sale. |
| ICP = (Inventory ÷ COGS) (360) | ACP = (Acct. Rec’vble ÷ Credit Sales) (360) |
| ICP = ($500,000 ÷ $4,500,000)(360) = | ACP = (2,000 ÷ 20,000) (360) = |
| 40 Days | 36 Days |
Some analysts will use a 360-day year, as above, based on the notion that there are twelve 30-day months to the year. We hasten to add that many analysts prefer the 365-day year. The difference is generally immaterial.
The firm pays (in this case, for its raw materials) in 32 days, but only collects on its working capital in 76 days. Let’s examine this further.
| Inventory Conversion Period | Average Collection Period |
| 40 Days | 36 Days |
| 76 Days | |
Again, the firm collects in 76 days altogether, but it pays in 32!
| PPP | Cash Conversion Period |
| ICP + ACP – PPP = | |
| 40 + 36 – 32 = | |
| 32 Days | 44 Days |
| 76 Days | |
Sample Company takes 76 days (ICP + ACP) to convert raw materials into finished goods, sell it, and collect its receivables. However, from the time it purchases the raw materials, until the firm pays for it, only 36 days pass, leaving 44 days during which time the firm must finance its current assets. The graph below illustrates, in summary, this 76-day period:
Cash Cycle with Financing Requirement
Sample Company
| 0 | 32 | 40 | 76 |
| Cash Financing Period | |||
| Purchase Raw Materials | Convert to Final Goods and Sell | Collect receivables | |
| ICP | |||
| ACP | |||
| Pay Accounts Payable | Finance Payable (44 days) | |
| CFP (Cash Financing Period) | ||
On the 32nd day, the company pays its suppliers with funds it has financed one way or another, and it pays down its financing when it collects on its receivables on the 76th day.
It must pay for the current assets with some form of short-term borrowings on which it will pay interest for an average of 44 days. If the firm can shorten its CCC (Cash Conversion Cycle), its interest expense will go down, with positive benefits to profits and share price. Can it do that?
