Cash Conversion Cycle

The cash conversion cycle measures the time it takes for a company to convert its sales of merchandise into cash. It is a key metric used to assess a company’s liquidity.

Components of the Cash Conversion Cycle:

• Accounts Payable Period: The time it takes for a company to pay its accounts payable.
• Accounts Receivable Period: The time it takes for a company to collect payment from its accounts receivable.
• Inventory Conversion Period: The time it takes for a company to sell its inventory and collect payment.

Formula:

Cash Conversion Cycle = Accounts Payable Period + Accounts Receivable Period + Inventory Conversion Period

Example:

A company has the following information:

• Accounts Payable Period = 10 days
• Accounts Receivable Period = 20 days
• Inventory Conversion Period = 15 days

Cash Conversion Cycle = 10 days + 20 days + 15 days = 45 days

This means that it takes the company an average of 45 days to convert its sales of merchandise into cash.

Interpretation:

• A low cash conversion cycle indicates that the company is collecting payment quickly and paying its accounts payable promptly.
• A high cash conversion cycle indicates that the company is taking longer to collect payment or pay its accounts payable.
• Companies with a low cash conversion cycle have an advantage over competitors because they have more cash on hand to invest or use for other purposes.

Uses:

• To assess a company’s liquidity and ability to meet its financial obligations.
• To compare companies’ cash conversion cycles and identify those with similar or differing liquidity profiles.
• To track trends in a company’s cash conversion cycle over time.

Additional Factors:

• Company size and industry
• Seasonality of the business
• Economic conditions
• Inventory management practices
• Accounts receivable and payable policies