June 2nd, 2008
Part 1 describe what’s cash conversion cycle(ccc) which basically is the length of time(in terms of days) working capital is tied up.
This article looks at how to compute cash conversion cycle and how we can improve it:
COMPUTATION OF CASH CONVERSION CYCLE
Company XYZ has the following:
- Annual sales of $15m
- Cost of goods sold- 80% of sales
- Average inventory-$1.5m
- Average receivables-$1.2m
- Average payables -$0.8m
Cash Conversion Cycle’s formula
= [ Inventory conversion period PLUS Receivables collection period DEDUCT/MINUS Payable deferral period ]
Inventory conversion period
= Inventory/Costs of Goods sold x 360 days
= $1.5m x 360 days
$15 x 0.8
= 45 days
Receivables Collection period/Days Sales Outstanding
= Receivables/Sales x 360 days
= $1.2 x 360 days
= 28.8 days
= Payables/Cost of goods sold x 360 days
= $0.8 x 360 days
$15 x 0.8
= 24 days
Cash Conversion Cycle(CCC)=(45+28.8-24) days = 49.8 days
HOW TO IMPROVE CASH CONVERSION CYCLE?
From the above illustration, we can see that the way to improve cash flow is to improve or reduce the cash operating cycle or to shorten the gap of this cash operating cycle from the time we received the goods until the time we received money from our accounts receivables and to optimize the time period of payment to our accounts payable.
The ways we can improve Cash Conversion Cycles are to focus on the three key components viz inventory, receivables and payables:
· Increase inventory turnover without causing any stock-outs
· Improve cash collection period without driving away customers/sales.
· Maximizing credit period of trade creditors/accounts payables without damaging the firm’s reputation.
[ Go to my another article on detailed improvement of cash conversion cycle in my other blog ]