Preface: Managing cash flows adroitly is an important task to every business owner. Continuing reading to learn how the cash conversion cycle works, and what you should be aware of to optimize its role in monthly and quarterly cash flows.
Cash Conversion Cycles
By Jacob M. Dietz, CPA
Imagine if you had $5,000 in cash, and you locked it in your safe. Unfortunately, you dropped the key into the bottom of a river while walking across a bridge. You call the safe company, and they agree to come and unlock your safe for you – in 15 days. That $5,000 is legally yours, and it is sitting right in front of you. You have every legal right to it, but it does you no good without a key. Understanding cash flow and taking steps to improve it can be a key to unlock cash flow.
Specifically, the Cash Conversion Cycle measures the days your cash is tied up in accounts receivable, the days it is tied up in inventory, and then subtracts the amount of time you save by using accounts payable.
Cash Conversion Cycle
The Cash Conversion Cycle is a measure of how many days your cash is tied up in a noncash form during your business cycle. Specifically, the Cash Conversion Cycle measures the days your cash is tied up in accounts receivable, the days it is tied up in inventory, and then subtracts the amount of time you save by using accounts payable. The specific calculations are beyond the scope of this article, but in general accounts receivable days are a measure of how many days it takes to collect your accounts receivable, inventory days is a measure of how long your inventory is around, and accounts payable days is a measure of how long it takes to pay your accounts payable.
Cash Conversion Cycle = Accounts Receivable Days + Inventory Days – Accounts Payable Days.
Suppose Mapleberrytown Widget Mfg, LLC is a manufacturing company that buys in widget components, manufactures widgets, and then sells the widgets to distributors. When they begin looking at their Cash Conversion Cycle, it is 150 days. Their accounts receivable days are 35, their inventory days are 130, and their accounts payable days are 15.
150 days = 35 accounts receivable days + 130 inventory days – 15 accounts payable days.
First, let’s look at accounts receivable. Is 35 days good or bad? Compare the number your business’ historical trends and to the industry. In this case, Mapleberrytown Widget’s industry standard is 30 days. Their historical trends reveal that 1 year ago their accounts receivable days were 33, and 2 years ago their accounts receivable days were 32.
Both the industry comparison and the historical comparison indicate a problem. What can they do? In Mapleberrytown’ s specific situation, they realize that they some customers are paying in 50 or 60 days, even though the invoices are supposed to be paid in 30 days. Upon closer inspection of the invoices, Mapleberrytown realizes that they do not indicate a timeframe to pay them. They immediately started printing a note on the invoices indicating that they are due in 30 days. Mapleberrytown decided to send out statements every month to late customers asking for payment.
Conclusion of Segment I.