The Cash Conversion Cycle

The odds are that you’ve stumbled across the term cash conversion cycle, and you want to comprehend its individual specifications. This is what we’re going to focus on in this post – on briefly outlining the characteristics of this cash flow calculation.

For one thing, this calculation focuses on measuring the amount of time a company needs to convert investments in inventory. That is to say, the cash conversion cycle calculation must determine how long the cash is tied to inventory before it generates revenue.

To begin with, the cash cycle features three distinct parts. The very first part of the cycle constitutes the current inventory level, outlining the amount of time it takes a company to sell inventory. Moving on to the second stage, it represents the current sales, as well as the time it takes in order to collect the cash from the sales.

As for the third stage, it accounts for the current outstanding payables. In other words, it outlines how much a company owes its existing vendors for both inventory and goods purchases.

The Formula of the Cash Conversion Cycle

In order to calculate the cash conversion cycle, you have to follow this formula:

So, as you can see, before you proceed to actually calculating the cash conversion cycle, you must complete these three smaller calculations.

Analyzing the Cash Conversion Cycle

Let’s consider an example, shall we? In the situation in which a retailer has bought inventory on credit from its vendors, a payable is usually established. Nevertheless, the company isn’t necessarily required to pay in cash right away. In general, the payable has to be paid within 30 days.

At the same time, the inventory is usually marketed to customers, and, at the right time, sold to clients on the account. From that point onward, the customer has to pay for the inventory, typically within 30 days after purchasing it.

Thus, the actual cash cycle has to measure the number of days between the payment of the vendor for the inventory and the time of receiving the cash from the customers. Similar to most cash flow calculations, shorter calculations are better. More specifically, a small conversion cycle clearly points out that the company’s money is tied to the inventory for a restricted amount of time. That is to say, the company is likely to generate revenue in a rather limited timeframe.

Hence, we could say that the cash conversion cycle is, in many ways, a sales efficiency calculation. That’s because it displays how quickly and efficiently a company is likely to buy, sell and collect on its inventory.

In summary, this calculation is useful for both investors and financial analysts and managers, as it clearly points out the operating efficiency of a company. Sales efficiency calculations provide insight into a firm’s capabilities and abilities. And, considering that the cash conversion cycle could be seen as a sales efficiency calculation, it is useful on many levels.