Question

 

1. What is a company's cash conversion cycle and why is it important?

2. What is the likely impact of a shorter credit period on accounts receivable?

3. What is the likely impact of a loose credit policy on sales?

Answer 1

1. Company's cash conversion cycle and its importance

Cash conversion cycle is a measure that shows in days, the amount of time that the entity takes to convert its inputs (that is, its investments in raw materials ) to cash. The formula is :

CCC = I + S - P

(in days)

where I = Inventory Outstanding

S = Sales Outstanding

P = Payables Outstanding

Each of the variables in the above equation forms the part of the process in the conversion. "I" measures the number of days the entity takes to convert its inventory to sales. Next is "S" which measures the number of days taken by the entity to realise its receivable after making the sales. Lastly, "P" which is deducted from the equation measures the number of days it takes for the entity to meet its payables.

CCC is very important in keeping track of the working capital flows of the entity since it measures the ability and the efficiency to both pay off its debts and recover its receivables. It indicates any solvency problem that may arise if not corrected.  Also, comparing the CCC of ones' own entity with others in the industry helps gauge the performance of the entity in relation to similar entities. If compared with previous years, it may also help in finding out about performance over the years.

(2) Impact of a shorter credit period on accounts receivable

Selling on credit is actually a tool to help both parties, wherein the seller can increase the sales while the buyer can avail some time to pay the money for the goods bought. This has a huge impact on the Cash cycle of the buyer and the seller. Credit if given properly can be beneficial to both parties. The problem arises when the credit period is not set properly.

For eg, if XYZ is an entity which regularly requires cash for working capital. It has given 4 months credit period to its customer. Now what happens here is that there is a huge time gap between the sales (resources going out) and cash received( resources coming in). So cash deficiency can occur in this time since expenses and payable are to be met, but there's no cash coming in. This may ultimately lead to insolvancy.

By reducing the credit period, a company can improve its cash cycle. Now there is a steady flow of cash coming into and going out of the entity. This keeps the business solvent and increases opportunities for reinvestment of profits. It may also help expand the business. This also helps in keeping up with the debtors and collecting the money regularly.

(3) The impact of a loose credit policy on sales

Every entity needs to have in place an effective and efficient credit policy in place. It should be flexible enough so that small changes can be made easily. Every business needs cash to survive. So if there is a large time gap between the inflow and the outflow, problems start occurring. If the credit period given is too short even the customers would be very less. On the other hand, if the credit period is longer, the customer base may be much higher and sales will therefore increase.

Loose credit and collections policies can sometimes negatively affect cash flow and hinder the cash flow system in the entity. Sometimes a loose or lenient policy may lead to a high risk of clients failing to pay on time. But the entity may still, have cash obligations to meet.That is why credit policy must be put in place after careful considerations of both the entity's creditors and the entity's customer base.