Question

Please, address each of the questions below, in 100-150 words (per question). Include any relevant examples and links to your sources.

1. 1. What is a company's cash conversion cycle and why is it important? 2. 2. What is the likely impact of a shorter credit period on accounts receivable? 3. 3. What is the likely impact of a loose credit policy on sales?

Answer 1

1. company's cash conversion cycle

The cash conversion cycle (CCC) is a measure of time indicated in days needed to convert inventory investments and other resources into sales-derived cash flow. Also known as a net operating cycle or simply cash cycle, cash conversion cycle determines how long a net input dollar stays non-liquid from production to sale before it is received as cash. Determining a company’s cash conversion cycle involves three key factors: how long it takes for its inventory to be sold, its accounts receivables (AR) to be collected; and its accounts payables (AP) to be settled without penalties. While AR and inventory are considered short-term assets, AP is a liability.

You can express a company’s operational and management efficiency through different metrics, including cash conversion cycle. A pattern of consistent or declining cash conversion cycle values over significant periods is positive news, while the opposite should prompt investigation and analysis of other related elements. Note that cash conversion cycle only applies to inventory-dependent businesses.

cash conversion cycle is also known as operating cycle , capital cycle , or cash cycle.

It indicates the length of time between a company paying cash for raw meterials, converting raw meterials into work in progress and finished goods, selling stock of finished goods and recieving cash from debtors.

operating cycle can be determined by adding number of days of each stage in operating cycle.

It is expressed in terms of number of days or months.

operating cycle in manufacturing concern

CASH --- RAW METERIALS --- WORK IN PROGRESS --- FINISHED GOODS --- SALES --- ACCOUNTS RECIEVABLES --- COLLECTION FROM RECIEVABLES --- CASH (again)

operating cycle = R + W + F + D - C

where, R = raw meterial storage period

W = work in progress holding period

F = finished goods storage period

D = debtors collection period

C = credit period allowed by creditors

Operating cycles are important because they determine cash flow. If a company is able to keep a short operating cycle, its cash flow will consistent and the company won't have problems paying current liabilities. Conversely, long operating cycle means that current assets are not being turned into cash very quickly.

2. impact of a shorter credit period on accounts receivable

Accounts receivable represents money owed to a business in return for goods already delivered or services already rendered. As an integral element of a company's cash flow, accounts receivable can impact several other areas of accounting, including accounts payable, financial statements, budgeting and collections. The average maturity of accounts receivable and the ratio of outstanding receivables to cash-based revenue both exert pressure on the rest of accounting. Understanding these impacts can provide guidance as you make decisions on your credit and collections policies.

Cash flow directly impacts your ability to pay short-term liabilities, including any current portions of long-term debt. If accounts receivable turnover time increases, a small business can be at risk of experiencing a negative cash flow, even if it has earned sufficient revenues to cover expenses and earn a profit. Revenue looks good on paper, but turning accounts receivable into cash is essential for a business to continue functioning. Consider your daily, weekly and monthly cash-flow needs to determine how much credit to extend to customers, taking care not to tip the balance so far in favor of receivables that you are unable to pay your own short-term liabilities.

Financial Statements : Accounts receivable are listed as assets on balance sheets, as revenue on income statements, and are excluded from cash-flow statements entirely. The amount of accounts receivable compared to inventory, cash and other assets can skew the accounts on a balance sheet in favor of illiquid assets. However, greater receivables have a purely positive effect on income statements, as they directly contribute to current-period revenue. The ratio of outstanding receivables to cash received in a period can impact the top and bottom lines of a cash-flow statement. In general, a shorter average maturity can increase current cash on hand.

Collection Approaches : Aging accounts receivable can impact the workload for collections specialists in the accounting team. A higher percentage of overdue receivables can distract limited accounting personnel from their daily routines in small businesses, decreasing departmental productivity. Aging receivables can also increase the loss a company takes due to writing off bad debts or selling them to third-party collections agencies.

Ratio Valuations : Since receivables are assets, account balances impact any financial ratio based on assets, including the debt-to-assets and assets turnover ratios. Because of its impact on cash flow, receivables also impact liquidity ratios such as the current, quick and cash ratios. The receivables turnover ratio is directly affected by the average maturity of accounts receivable as well, and is an important metric that banks, lenders and investors may analyze when making lending or investment decisions.

3. impact of a loose credit policy on sales

A credit policy outlines the terms under which customers who buy on account must repay the balance. Suppliers commonly extend credit accounts to regular buyers to encourage repeat business. A strict credit policy means enforcing tight limits on the amount of time a buyer can pay a debt.

Sales Slide : A primary reason companies extend credit is to encourage more frequent and higher-volume purchases. When borrowers can acquire inventory without an upfront cash payment, it gives them more flexibility to meet the demands of their own customers. Overly strict terms usually fly in the face of the credit system concept. Expecting buyers to repay within a week in an industry with a 30-day average payment cycle means your credit offering won't attract much attention. You also risk ruining relationships with existing buyers if you suddenly shift from moderate or loose policies to a tight payment window.

Inventory Issues : Damaging relationships with buyers can lead to unexpected expenses. Stockpiled inventory is costly to manage. At some point, you may have to lower prices to clear the backlog. Carrying items that expire or become obsolete may lead to throwing them out. The time, effort and energy you put into managing excess inventory also takes focus from more strategic endeavors.

The Plus Side : A tight policy isn't all bad, though, as it offers the potential for better short-term cash flow. The sooner the cash is in hand, the sooner you can pay your own creditors and acquire more inventory. Ideally, your policy should be viewed as fair rather than too tight or too loose. A fair policy that fits with industry norms typically leads to the best combination of ongoing business, cash flow and a low number of collections accounts.

Enforcement Pressure : Tighter credit policies also put pressure on your billing and payments staff to enforce them. Faster payment requirements mean invoices and bills must go out the door that much sooner. You also have to follow up diligently with buyers who don't make payments with phone calls and letters. This constant communication can burden an already busy staff and the constant calls and letter reminders can further erode a buyer's perception of your business.