Bakersfield Office    
661 527 9080
Central Coast Office
805 585 5760

What is the Cash Conversion Cycle: it measures how quickly a company converts cash into more cash. Keeping on top of your accounts receivable and payables is essential in an inflationary environment. While official government measures show inflation around 3 percent, the reality feels a lot different at the gas pump and with our vendors. Many business owners also will be painfully aware that financing rates are much higher than they were several years ago.

The Impact of Inflation

Inflation can significantly impact each component of the Cash Conversion Cycle:

  • Inventory: In an inflationary environment, the cost of raw materials and finished goods may increase. This can lead to higher inventory costs, which may require businesses to adjust their pricing strategies or find ways to optimize inventory management to maintain profitability.
  • Accounts Receivable: As inflation rises, customers may take longer to pay their invoices, leading to an increase in Days Sales Outstanding. This can put additional pressure on a company’s cash flow, especially if the company is unable to collect payments in a timely manner.
  • Accounts Payable: Businesses may try to extend their payment terms with suppliers to conserve cash during inflationary times. However, suppliers may also be facing similar challenges and could be less willing to offer extended payment terms. This can lead to a decrease in Days Payable Outstanding, further straining cash flow.

By closely monitoring the Cash Conversion Cycle during inflationary periods, business owners can identify areas where they need to adapt their strategies to maintain financial stability and profitability.

The Operating Cycle

The first important financial metric is called the Operating Cycle. This is particularly useful for companies that sell products (rather than services). This measures the number of days a company makes one complete operating cycle, i.e. the process of purchasing merchandise, selling it, and collecting the payment due. A shorter operating cycle means that a company generates sales and collects cash faster.

Calculating the Operating Cycle is done by adding two financial ratios together: Days Inventory Outstanding (also known as “inventory turnover in days”) and Days Sales Outstanding (also known as “receivables turnover in days” and “collection period”).

How does this help the business owner? The best application of the Operating Cycle is to calculate the results either every month or quarter. These results should then be charted to visually track your performance. If the performance is deteriorating (i.e. is taking longer) then you should investigate both your inventory levels and how long it is taking to collect payment.

Let’s dive into an example and assume a company has the following financial information:

  • Inventory: $100,000
  • Cost of Goods Sold (COGS): $500,000
  • Accounts Receivable: $150,000
  • Sales: $750,000
  • Accounts Payable: $80,000

Days Inventory Outstanding = (Inventory / COGS) × 365 = (100,000 / 500,000) × 365 = 73 days
Days Sales Outstanding = (Accounts Receivable / Sales) × 365 = (150,000 / 750,000) × 365 = 73 days

Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding = 73 + 73 = 146 days

The Cash Conversion Cycle

The second important financial metric is called the Cash Conversion Cycle. This measures how quickly a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and then collects the amount due. Generally, like the Operating Cycle, the shorter the Cash Conversion Cycle the better.

The Cash Conversion Cycle is made up of three components: Days Inventory Outstanding plus Days Sales Outstanding (the Operating Cycle) less Days Payable Outstanding (“DPO”). DPO is also known as accounts payable in days or the payment period. Generally we like to see a longer DPO than a shorter one.

To calculate the Cash Conversion Cycle:
Days Payable Outstanding = (Accounts Payable / COGS) × 365 = (80,000 / 500,000) × 365 = 58.4 days
Cash Conversion Cycle = Operating Cycle – Days Payable Outstanding = 146 – 58.4 = 87.6 days

Cash Conversion Cycle

Cash Conversion Cycle

 

What Does It Mean?

Again, the business owner should track these measures either monthly or quarterly. Is your business performing better or worse over time? It is important to measure the impact of each component.

  • Inventory turnover: if it’s too low, do you have too much inventory or are carrying too many products? Are there ways you can optimize your inventory with better ordering practices?
  • Days Sales Outstanding: if it’s high, are you giving your customers too much time to pay their invoices? Would offering a discount for prompt payment assist your business cashflow?
  • Days Payable Outstanding: if it is low, what are the terms of your payments with your suppliers? Is your payment due date too soon and can you renegotiate your terms? Or are you paying too quickly and can you stretch this out without disrupting your vendor relationships?

Understanding your working capital requirements through the Operating Cycle and the Cash Conversion Cycle are critical to navigating adverse business environments. Companies that improve their liquidity by adopting efficient working capital management strategies will be able to emerge from this crisis in a stronger position.

If you wish to learn more about how Central Pacific Valuation can help you understand your Cash Conversion Cycle, please click here.

Kevin Lowther, AM, ABV, FMVA is a partner with Bakersfield-based Central Pacific Valuation.  He provides business valuation and financial analytics services. Kevin can be reached here.