# 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?