Question

Describe the cash conversion cycle and its importance to working capital management. For each segment of the cycle, discuss a specific policy a business can enact, and its effect on the overall cash conversion cycle (250-350 words).

Answer 1

Cash Conversion Cycle is the period in which cash outflow is converted back to cash inflow. It is period between inventory purchased and cash received from sales

Cash Conversion Cycle = Inventory Holding Period + Days Receivable - Days Payable

Hence there are 3 factors in CCC.

We should try to reduce the CCC as much as possible so that there is quick churning of money.

Inventory Holding: Inventory should be kept at most optimal levels. There should not be over stocking. Also enough inventory should be kept so that no customer is lost. It is imperative to strike a balance in inventory. There are various startegies in which inventory can be managed like just in time, economic order quantity etc.

Days Receivable: We should try to receive the cash as quickly as possible. Sometimes credit period is given in order to increase sales. But that results in more probability of default. Credit period should be kept at a level so that the benefits from excess sales exceeds the risk from default.

Days Payable: We should try to negotiate higher credit terms as far as possible. It is very important to maintain the relation with the vendors. As we need to keep the quality of inputs constant and there should not be any shock. After proper negotiation, credit period should be availed such that interest of both the parties are maintained.