When evaluating cash flow, those factors directly affecting profit, revenue and expenses, are easy to understand and their affect on cash is straight forward; decreases in costs or increases in profit margin results in less cash going out or more cash coming in, and increased profits.
However, the working capital components of the Cash Conversion Cycle are a little more complex. In simple terms, an increase in the amount of time accounts receivables are outstanding uses up cash, a decrease provides cash; an increase in the amount of inventory uses cash, a decrease provides cash; an increase in the amount of time it takes you to pay your payables provides cash, a decrease uses cash.
For example, a decision to buy more inventory will use up cash, or a decision to allow people to pay for goods or services over 60 days instead of 30 days will mean you have to wait longer for payment, and will have less cash on hand.
Below is a numerical example of the cycle:
Accounts Receivable outstanding in days +90
Inventory in days +60
Accounts Payable outstanding in days -72
Cash Conversion Cycle +78
In the scenario, you have cash tied up for 78 days. It should be noted that you can have a negative conversion cycle. If this occurs it means that you are selling your inventory and collecting your receivables before you have to pay your payables. An ideal situation if you able to accomplish this. Before you say it is impossible, remember that companies such as Wal-Mart are today selling a large part of their inventory before they have to pay for it. While it is not easy it can be accomplished.
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