Calculating cash flow is one of
most important tasks of business owner. Revenue and expenses are rarely constant in a business and cash requirements need to be planned for shortfalls, seasonal factors or one time large payments. At end of day, a company that cannot pay its bills is bankrupt. Unfortunately, while many business owners concentrate solely on their revenues and expenses to manage their cash flow, it’s usually poor management of cash conversion cycle that so often leads to a cash crunch in business.What is cash conversion cycle and why should I be concerned with it?
The cash conversion cycle is simply duration of time it takes a firm to convert its activities requiring cash back into cash returns. The cycle is composed of three main working capital components: Accounts Receivable outstanding in days (ARO), Accounts Payable outstanding in days (APO) and Inventory in days (IOD). The Cash Conversion Cycle (CCC) is equal to time is takes to sell inventory and collect receivables less time it takes to pay your payables, or:
CCC = IOD + ARO – APO
Why is this cycle important? Because it represents number of days a firm's cash remains tied up within operations of business. It is also a powerful tool for assessing how well a company is managing its working capital. The lower cash conversion cycle, more healthy a company generally is. If you compare results of cycle over time and see a rising trend it is often a warning sign that business may be facing a cash flow crunch.
Understanding components of cycle
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, working capital components of CCC are a little more complex. In simple terms, an increase in amount of time accounts receivables are outstanding uses up cash, a decrease provides cash; an increase in amount of inventory uses cash, a decrease provides cash; an increase in 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 cycle:
Accounts Receivable outstanding in days +90 Inventory in days +60 Accounts Payable outstanding in days -72 Cash Conversion Cycle +78
In 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.
