TREASURY ESSENTIALS THE CASH CONVERSION CYCLE Efficient management of working capital is crucial to business success. Sarah Boyce explains how it’s done
While large, one-off investments Figure 2: The cash conversion cycle can be funded through raising new finance from the debt and Raw materials Payment Goods sold Payment equity markets, it is the funds from purchased made received ongoing operations that service debt, pay dividends and pay for labour, goods and services.
In simplest terms, such funds are Days inventory generated by the receipt of income from the sale of goods and services. More Days receivable specifically, a supplier (creditor) provides stock, the stock is then sold on credit, Days payable creating a debtor. In due course, the Cash conversion cycle debtor pays, thus providing the company with cash resources that are then used to pay the creditor and the surplus cash they will need to be paid, the company cycle (by reducing inventory or collecting is retained within the business. This is still has access to the funds until payment cash more quickly) and/or by delaying the working capital cycle. is made.) payments to suppliers. Together, this results in the CCC. The CCC can even be negative – for Figure 1: Elements of the working capital cycle The formula for calculating the CCC is instance, if the company has a strong as follows: market position and can dictate terms to CCC (days) = days inventory outstanding customers and/or suppliers (for example, Trade payables Purchase + days receivable outstanding – days if it can postpone its payments). to pay payable outstanding Benchmarking the CCC against a peer group rather than companies in general Inventory Order to Where: is often more valuable since, for example, delivery Days inventory outstanding = some industries have no inventory (such
Trade receivables (average inventory/cost of goods sold) as transport companies), some have no Order to cash x 365, ie the average number of days it receivables (for example, supermarkets) takes for inventory to be sold. A lower and others have no creditors, usually number is generally desirable while still because no one trusts their credit. The three key components of ensuring that sales demand can be met. working capital are trade receivables, Days receivable outstanding = Conclusion trade payables and inventories, and their (average accounts receivable/sales) Good management of the CCC supports control (ie working capital management) x 365, ie the average number of days it cash flow forecasting and enables better is critical to the liquidity of the company. takes for a company to collect payment. long-term funding and investment So, although this may not be viewed as an A lower number is desirable while decisions, a reduced risk of bad debts, exciting area of finance, it is crucial to the ensuring that the organisation does not improved liquidity and hence stronger long-term success of any organisation. put itself at a competitive disadvantage to balance sheet ratios (and from this, The cash conversion cycle (CCC) – is other potential suppliers through overly increased creditworthiness). a measure of how long cash is tied up in aggressive settlement terms. There are practical, operational and working capital. It quantifies the number Days payable outstanding = (average commercial limitations on how low of days it takes a company to convert accounts payable/cost of goods sold) working capital levels can fall without cash outflows into cash inflows and, x 365, ie the average number of days it adversely affecting operations and therefore, the number of days of funding takes a company to pay its creditors. A relationships, however. As a result, required to pay current obligations and higher number is desirable, but a balance the management of working capital is stay in business. needs to be maintained between delaying essentially a compromise between levels The operating cycle – which consists payment and retaining the goodwill of high enough for smooth commercial of money tied up in receivables and suppliers or taking advantage of any early operation and levels low enough to be inventory (the red bars on the chart, payment terms. financially efficient. above right) – is offset by trade payables, The shorter the CCC, the healthier a which are a source of liquidity. (While company generally is. Businesses shorten Sarah Boyce is associate director of they represent a future use of funds since the CCC by condensing the operating education at the ACT
46 The Treasurer October 2014 www.treasurers.org/thetreasurer