Cash Conversion Cycle
Cash conversion cycle is an efficiency ratio which measures the number of days for which a company’s cash is tied up in inventories and accounts receivable. It is aimed at assessing how effectively a company is managing its working capital.
A typical business purchases raw materials (mostly on credit), converts them to finished products, sell those products (mostly on credit), recovers cash from customers and reuses the cash to purchase raw materials for further production and so on.
We defined cash conversion cycle as the time for which cash is tied up in working capital (i.e. inventories and receivables). The days for which cash is tied up in receivables is measured by days’ sales outstanding (DSO) and the number of days it takes to sell inventories is measured by days’ inventories outstanding (DIO). The sum of these two ratios is the company’s operating cycle. However, since raw materials consumed in production of inventories is purchased on credit, and hence paid after the relevant raw materials have been used in production, the actual days for which cash is tied up in inventories equals days it takes to sell inventories minus days for which the amount payable against those raw materials remained outstanding, i.e. days payable outstanding (DPO).
The following timeline shows the relationship between operating cycle, cash conversion cycle, DSO, DIO and DPO:
Cash Conversion Cycle = DSO + DIO – DPO
DSO is days sales outstanding = Average Accounts Receivable × 365 ÷ Credit Sales
DIO is days inventory outstanding = Average Inventories × 365 ÷ Cost of Goods Sold
DPO is days payables outstanding = Average Accounts Payable × 365 ÷ Cost of Goods Sold
Alternatively, it can also be calculated using the following formula if we know the operating cycle:
The figures for credit sales, cost of goods sold, average accounts receivable, average inventories and average accounts payable can be obtained from the company’s financial statements.
Cash conversion cycle is an important ratio, particularly for companies that carry significant inventories and have large receivables, because it highlights how effectively the company is managing its working capital.
Cash conversion is most useful in conducting trend analysis for companies in the same industry. Generally, short cash conversion cycle is better because it tells that the company’s management is selling inventories and recovering cash from those sales as quickly as possible while at the same time paying the suppliers as late as possible.
Calculate and analyze the cash conversion cycle for Hewlett-Packard (NYSE: HPQ) and Apple, Inc. (NYSE: AAPL) based on the information given below (as obtained from Morningstar):
|Days Sales Outstanding||52.51||52.46||48.65|
|Days Payables Outstanding||55.51||57.82||64.37|
|Days Sales Outstanding||19.01||25.66||30.51|
|Days Payables Outstanding||74.39||74.54||85.45|
Cash conversion cycle for HPQ for 2012 = 52.51 + 27.27 – 55.51 = 24.27
The following table shows cash conversion cycle for both companies for the three years.
AAPL has negative cash conversion cycle of 44 to 52 days during the three-year period which suggests an exceptionally good working capital management. It means that AAPL could sell and receive cash from its sales even 44 to 52 days before it actually made payments against its production inputs, which is impressive.
HPQ on the other hand drastically improved its cash conversion over the three years i.e. from 24.27 in 2012 to 11.09 in 2014, which suggests significant improvement in efficiency of the company. Still HPQ’s working capital management is not as good as AAPL. AAPL has been able to leverage its very strong market position to receive generous credit terms from suppliers.