Cash Conversion Cycle

This reading explains the cash conversion cycle and its components, the cost of trade credit and measures of working capital, and how to compare issuers on them. It then covers primary and secondary sources of liquidity, drags and pulls on liquidity, liquidity ratios, and conservative, moderate and aggressive approaches to managing working capital.

LOS 23.a — The cash conversion cycle

The cash conversion cycle (CCC), also called the net operating cycle, measures how long a company's cash is tied up between paying for inventory and other resources and collecting cash from the resulting sales:

• Days of inventory on hand (DOH): how long inventory is held before it is sold;
• Days sales outstanding (DSO): how long customers take to pay (average days of receivables);
• Days payable outstanding (DPO): how long the company takes to pay its suppliers (average days of payables).

The operating cycle is the time from receiving materials to collecting cash from the sale, so it equals $\text{DOH}+\text{DSO}$. Suppliers finance the first DPO days of it, so the CCC is the part of the operating cycle that the company must finance itself.

From turnover ratios to days. Activity data are often given as turnover ratios, so convert them to days first (365-day year):

1. $\text{DOH}=365/\text{inventory turnover}$, where $\text{inventory turnover}=\text{cost of goods sold}/\text{average inventory}$;
2. $\text{DSO}=365/\text{receivables turnover}$, where $\text{receivables turnover}=\text{revenue}/\text{average receivables}$;
3. $\text{DPO}=365/\text{payables turnover}$, where $\text{payables turnover}=\text{cost of goods sold (many analysts use purchases)}/\text{average trade payables}$;
4. $\text{CCC}=\text{DOH}+\text{DSO}-\text{DPO}$.

A lower CCC is generally better: less capital is tied up in working capital and cash is generated faster. A CCC that is high relative to peers may signal excessive investment in working capital and possible cash flow strain.

Because the CCC is a linear combination of its components, scaling every component by the same factor scales the CCC by that factor. A percentage change in one component is not the percentage change in the CCC. In the timeline example, if DPO rises from 25 to 35 days (the firm negotiates longer supplier terms), the CCC falls to 45 days: DPO rose 40%, but the CCC fell about 18%.

A company can shorten its CCC by working on any of the three components, but each lever has a cost:

Trade credit and its cost

Accounts payable are an implicit source of credit from suppliers (bank loans are an explicit source). Terms a/b net c mean a discount of $a$ (a percentage) if paid within $b$ days, otherwise the full amount is due by day $c$. Skipping the discount is borrowing $(1-a)$ per $1 of invoice for $(c-b)$ days at a cost of $a$:

where $a$ is the discount as a decimal, $b$ the days until the discount expires and $c$ the days until full payment is due.

Comparing CCCs

CCCs differ by industry. Pharmaceutical firms, for example, carry large inventories (long CCC); airlines collect cash before providing the service and hold little inventory (short CCC). Compare a firm with its own industry or with its own history. Scale working capital by sales to compare firms of different size, and compare only firms in similar lines of business, because the ratio varies by industry. A company with a short CCC ties up less working capital for each unit of sales, so the two measures usually point the same way. Analysts often prefer net working capital, built from operating items only, because it ties closely to the CCC:

LOS 23.b — Liquidity

Liquidity of an asset is its nearness to cash; of a liability, its nearness to settlement. Inventory is less liquid than receivables (it must be sold, then collected).

Current asset	What must happen before it becomes cash	Liquidity
Cash	Nothing	Highest
Marketable securities	Sell them in the market	Very high
Accounts receivable	Collect from customers	Lower
Inventory	Process (if needed) and sell, then collect the receivable	Lowest

For an issuer, liquidity is the availability of cash and liquid assets to meet short-term obligations. Long-term solvency depends on generating enough cash from the business to service liabilities, and analysts judge liquidity management mainly from the statement of cash flows. Companies normally rely on primary sources and turn to secondary sources only when needed.

Secondary sources are costlier and send a negative signal to the market. Cash buffers cost money (idle capital) but reduce the risk of having to rely on secondary sources when the CCC deviates from normal (seasonality, demand shocks).

• A drag on liquidity delays cash inflows: slow-moving or obsolete inventory (DOH ↑), slow or uncollectible receivables (DSO ↑).
• A pull on liquidity accelerates cash outflows: suppliers cut credit lines or demand faster payment (DPO ↓).

The cost of liquidity is the discount to fair value accepted when assets must be sold quickly. Example. $50 of cash (0% cost), $150 of receivables and inventory sold at a 10% discount, and $200 of equipment sold at a 25% discount give proceeds of $50+135+150=\$335$ against a fair value of $400; cost $=\$65=16.25\%$.

Liquidity ratios

A current ratio above 1 means current assets are enough to cover current liabilities. The quick ratio excludes inventories, the least liquid current asset, so it is more conservative than the current ratio; the cash ratio also excludes receivables and is the most stringent. Example. With cash 30, receivables 50, inventory 90 and current liabilities 100, the current ratio is 1.70, the quick ratio 0.80 and the cash ratio 0.30.

LOS 23.c — Managing working capital and liquidity

Working capital management tries to maximize profit while keeping enough liquidity to run the business and meet obligations. Holding more short-term assets is safer but earns less; financing with short-term debt is cheaper than long-term debt or equity but carries rollover risk. Compare firms by scaling short- and long-term assets by sales.

Permanent current assets are the level of current assets the business needs all year; variable (seasonal) current assets are the extra amount needed at peak times. For the same assets, the approaches differ in how far long-term debt and equity reach up this stack of needs; the rest is funded short term:

Factors in choosing short-term funding: company size (small firms have fewer options), creditworthiness, the legal system (lender protections), regulation (e.g., banks and utilities), and the underlying assets available as collateral. Firms should keep several funding sources, know their costs, and arrange them before they are needed.