Introduction
This document analyzes the impact of the cash conversion cycle on the financial performance of a firm. The purpose of the report is to provide a guideline for calculating, interpreting, and analyzing the cash conversion cycle. Most firms may prefer a shorter cash conversion cycle because it reduces the amount of working capital needed for operations. A shorter cash conversion cycle may not be attractive to customers, who seek longer credit alternatives.
Calculating the cash conversion cycle
Calculating the cash conversion cycle, using the values in the table below:
Brigham & Houston (2012) elaborate that the cash conversion cycle is obtained by adding the inventory conversion period to the average collection period and deducting the payables deferral period.
- Inventory conversion period = Inventory / cost of goods sold per day (Brigham & Houston, 2012).
- Inventory conversion period (from the above table) = $3 million/ ($14 million/ 365 days) = 78.21 days, which is rounded off to 79 days.
- Average collection period (or days’ sales outstanding) = Receivables/ (revenue/ 365 days) (Baker & Powell, 2009).
- Average collection period = $2 million/ ($20 million/ 365) = 36.5 days, which is rounded off to 37 days.
- Payables deferral period = payables/ purchases per day (Brigham & Houston, 2012).
- Payables deferral period = $2 million/ ($14 million/ 365) = 52.14 days, rounded off to 53 days.
- Cash conversion cycle (CCC) = 79 days + 37 days – 53 days = 63 days
Interpretation of CCC
The firm’s cash conversion cycle shows that the firm averagely waits for 63 days before it can convert current assets into cash. Baker & Powell (2009) explain that it is the amount of time it takes the firm to generate cash from its current assets. The CCC shows the length of time that the firm has to wait before it can collect cash from working capital, used to purchase inventory, and other inputs, used to convert the raw materials into sales (Cash conversion cycle, 2014). According to Brigham & Houston (2012), the CCC expresses the difference in time from when money is spent on factor inputs and the collection of cash from sales.
Analysis
It is difficult to determine whether the firm has a favorable CCC by considering the firm separately from the industry and competitors. The CCC should be improved if it is below the firm’s target. The inventory conversion cycle indicates that the firm is within an industry that takes a longer time before converting raw materials into finished goods. In that case, having 63 days, the CCC may be considered favorable to the firm. The firm’s CCC would be favorable in many industries, such as the fashion retail stores, and some others. It would be unfavorable in a fast-food store because it needs fewer inventories. It would be shorter for an automobile parts manufacturer.
A lower CCC is preferable for the firm. Reducing the CCC will depend on whether it will reduce sales. Sales may reduce if the average collection period component of the CCC is reduced to days that are less than 37. Customers may feel a lot of pressure and consider other credit alternatives. According to Brigham & Houston (2012), the reduction of the CCC should consider the possible reduction in sales. Favorably, reducing the CCC can increase the profitability of the firm by increasing efficiency in the utilization of current assets (Brigham & Houston, 2012). The stock price may also be appreciated because it will be less needed to raise funds in the financial markets to cover working capital, which incurs a capital cost. A firm with a higher net profit margin may choose to incur lower capital costs to boost higher sales. In that case, higher sales provide higher benefits than the opportunity cost of capital.
Some of the ways of reducing the CCC include collecting receivables more promptly, managing inventory more efficiently, and holding suppliers’ money for a longer period (Baker & Powell, 2009).
Calculating the CCC
CCC = inventory conversion period + average collection period – payables deferral period (Brigham & Houston, 2012). CCC = 62 days + 29 days – 40 days = 51 days.
Calculating investment in receivables given credit sales and average collection period
The investment in receivables can be calculated using the formula for calculating average collection period shown in Part I. It can be obtained by receivables, equal to the average collection period multiplied by sales and divided by 365 days.
Receivables = 29 days * $4 million/ 365 days = 0.31780822 million. It can also be expressed that the firm needs $317,808.22 to cover inventories.
Calculating the inventory turnover ratio given the inventory conversion period
The formula for this calculation can be derived from the inventory conversion period formula, inventory conversion period = 365/ inventory turnover (Obaidullah, 2014).
Inventory turnover ratio = 365 days/ inventory conversion period = 365 days/ 62 days = 5.887 times. It means that the inventories are replenished about 6 times in a year.
Conclusion
A lower cash conversion is preferable for the firm provided that it does not result in lower sales. The firm should consider the net profit margin and the cost of capital when determining whether to increase sales by extending credit to customers. The opportunity cost of capital can help the firm to make a better decision.
References
Baker, H., & Powell, G. (2009). Understanding financial management: a practical guide. Hoboken, NJ: John Wiley & Sons.
Brigham, E., & Houston, J. (2012). Fundamentals of financial management (7th ed.). Mason, OH: South-Western Cengage Learning.
Cash conversion cycle. (2014). Web.
Obaidullah, J. (2014). Cash conversion cycle. Web.