Cash Conversion Cycle(Part1 Of 2)

June 1st, 2008 Comments off
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Cash Conversion Cycle(CCC) is a close loop cycle which encompasses the following five (5) stages of normal operating business cycle:

 

1

The receipt of raw materials from suppliers;

2

Conversion of the raw materials into work in progress and finally to finished products;

3

Delivery of goods and billings to the customers/accounts receivable

4

Collection from the accounts receivable and

5

From the collections utilized to repay the accounts payable.

 

 

 

Formula For Cash Conversion Cycle(CCC)

Inventory conversion period + Receivables collection period – Payable deferral period

 

Three Key Components in Cash Conversion Cycle

In the Cash Operating Cycle, there are three (3) key components that we should focus upon:

  • Inventories whether in the form of raw materials, work-in-progress or finished goods
  • Accounts Receivables or trade debtors,
  • Accounts payable or the trade creditors

 

Inventory Conversion Period

 

· Is the average length of time(days) required to convert materials into finished goods and then to sell them.
· Formula:

Inventory/Sales x 360 days or

Inventory/Costs of Goods sold x 360 days

 

 

Receivables Collection Period or DAYS SALES OUTSTANDING (DSO)

 

· Is the average length of time(days) required to convert firm’s receivables into cash.
· Formula:

Receivables/Sales x 360 days or

 

Payables Deferral Period

 

· Is the average length of time(days) between the purchase of materials and labour and the payment of cash for them.
· Formula:

Payables/Cost of goods sold x 360 days

 

Salient points to note:

·

 

The length of time from the beginning of the production process to the point when cash is collected from the sale of finished goods is called operating cycle

·

 

Cash conversion cycle is not a new methodology at all. CCC’s existence is as old as when accountants were looking into ways of how to reduce or manage the dollars tied up in the working capital of accounts receivable and stocks and optimizing the period owing to accounts payables.

·

Cash Conversion Cycle is also known as Operating Business Cycle or Daily Working Capital.(in number of days)

·

 

CCC as a performance metric is indeed a very simple, easy to understand and to use & is a flexible tool for understanding the favourable or adverse changes in working capital management. In fact, surveys conducted by reputable accountancy bodies like CFO Asia.com includes CCC as part of their key performance metric to rank good performers amongst companies in similar industry
     

Refer next article(Part 2) on illustration on how to compute Cash Conversion Cycle.

 

 

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Financial Accounting

 
 

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