Question

explain the components of the cash cycle and how changes in these components can increase or decrease the cash cycle. What is preferable a negative or positive cash cycle? Why?

Answer 1

The three components of the cash conversion cycle are:

*Days inventory outstanding [DIO]

*Days sales outstanding [DSO]

*Days payable outstanding [DPO]

DIO:

It gives the average number of days it takes the raw

material to be convered to finished goods and then

to sales.

It is calculated as:

DIO = Average inventory*365/Cost of goods sold

DSO:

It gives the average number of days in which the

accounts receivable are collected.

It is calculated as:

DSO = Average receivables*365/Net credit sales

DPO:

It is the average no of days in which the accounts

payables are paid.

It is calculated as:

DPO = Average payables*365/Cost of goods sold

The cash conversion cycle is given by the formula:

CCC = DIO+DSO-DPO

Lower the resultant CCC in days the better it is for

the firm, as the investment in net working capital

would be lower. Hence, it would be in the interest

of the firm to keep the CCC to the minimum.

An increase in DIO and DSO will adversely affect

the CCC and their decrease will beneficially affect

the CCC. In the case of DPO an increase wil be

beneficial and a decrease will be detrimental.

PREFERENCE:

Theoretically speaking, a negative CCC would be

preferable, as it would mean financing the whole of

and more of the current assets with accounts

payables.

However, this would mean paying the suppliers

after collecting the receivables. In most industries,

such a strategy will be appreciated neither by the

suppliers nor by the credit customers. Both of them

would resent and that will affect the growth.

However, the positive CCC should be limited to the

minimum possible, without affecting the business.