Question

Having a good grasp on your firm’s cash conversion cycle is paramount for continued firm viability … especially for small or start-up businesses with limited access to capital. If you were a venture capitalist considering providing funding to a cash-constrained firm, what criteria could you use to assess the accuracy of their cash flow forecasts and the adequacy of their requested cash injection?

Answer 1

The cash conversion cycle (CCC) is a key measurement of small business liquidity. The cash conversion cycle is the number of days between paying for raw materials or goods to be resold and receiving the cash from the sale of the goods either made from that raw material or purchased for resale. The cash conversion cycle measures the time between outlay of cash and the cash recovery. The cycle is a measure of the time that funds are tied up in the cycle. The CCC measure illustrates how quickly a company can convert its products into cash through sales. The shorter the cycle, the more working capital a business generates, and the less it has to borrow.

Effective management of the cash conversion cycle is imperative for small business owners. Indeed, the CCC is cited by economists and business consultants as one of the truest measures of business's health, particularly during periods of growth. Other often used ratios and measures of a company's activity may not provide advance notice of a cash flow problem as well as the CCC. For example, the current and quick ratios are popular with companies and their bankers. However, in a period when collections have slowed, asset turns have become sluggish and vendors have not extended terms beyond previously agreed limits, a clearly worrisome combination, the current ratio would probably look good. At the same time, the quick ratio may even show improvement or remain steady, even though the company is actually in substantial need of working capital. This happens because of the balance-sheet-oriented limitations of current and quick ratios. These often used ratios do not work well on a company going through a period of rapid and dynamic change.

Instead of the potentially misleading measurements mentioned above, small business owners should consider using the cash conversion cycle, which provides a more accurate reading of working capital pressure on cash flow. The objective is to keep the CCC as low as possible. During periods of growth, the goal should be to strive to maintain a constant CCC. Unless inventory, credit, or vendor policies change, rapid growth should not cause the CCC to increase. The ease with which this ratio can be calculated makes it an even more attractive measure for tracking a business's operations and managing cash flow.

Cash conversion cycles for small businesses are predicated on four central factors: 1) the number of days it takes customers to pay what they owe; 2) the number of days it takes the business to make its product (or complete its service); 3) the number of days the product (or service) sits in inventory before it is sold; 4 the length of time that the small business has to pay its vendors. The following formulas may be used to determine these factors:

Accounts receivable days—divide the receivables balance by the last 12 months' sales, then multiply the result by 365 (the number of days in a year).

Inventory days—take the inventory balance, divide it by the last 12 months' cost of goods sold, and then multiply the result by 365.

Accounts payable days—take the company's payables balance, divide it by the last 12 months' cost of goods sold, and then multiply the resulting figure by 365.

Once a small business owner has these figures in hand, he or she can determine the company's cash conversion cycle by adding the receivable days to the production and inventory days and then subtracting the payables days. That will render the number of days a company's cash is tied up and is the first step in calculating how much money the company will want to secure for its revolving line of credit.

The cash conversion cycle (CCC) concept presents one possibility for measuring and

controlling the effectiveness of working capital management on the basis of relative ratios.

Richards and Laughlin (1980) developed the CCC to criticize the use of current ratio and

quick ratio as key indicators of a firm’s liquidity position. They state that the usefulness of

these static liquidity indicators is limited by their failure to provide adequate information on

cash flow attributes of the transformation process within a firm's working capital position.

Current ratio and quick ratio emphasize essentially liquidation, rather than a going-concern.

Richards and Laughlin stress that the focus of management should be on avoiding default

situations, and that cannot be supported by using ratios that indicate a firm’s ability to meet

its obligations through asset liquidation in the event of default. Shin and Soenen (1998),

Deloof (2003), Hutchison et al. (2007), and Ulbrich et al. (2008) have agreed that CCC is a

good proxy for working capital management.

The cash conversion cycle presents the length (in days) of time a firm has funds tied up in

working capital, starting from the payment of purchases to the supplier and ending when

remittance of sales is received from the customers. In other words, the CCC is a collection of

three activity ratios: the cycle time of inventories (DIO) plus the cycle time of accounts

receivable (DSO) less the cycle time of accounts payable (DPO). The DIO is calculated as

inventory×365/sales, the DSO as accounts receivable×365/sales, and the DPO as accounts

payable×365/sales. The importance of the CCC from the perspective of value chain

management is that it bridges purchasing activities with suppliers, internal supply chain

activities and sales activities with the customer (Farris and Hutchison, 2002).

Cash conversion cycle in the literature

The cash conversion cycle is also known as cash-to-cash (C2C). Where the parallel term

originated from, is not clear. C2C is widely used in managerial articles (e.g. Sherida, 2000;

Bowman, 2001; Ward, 2004) and supply chain management journal articles (e.g. Farris and

Hutchison, 2002), whereas CCC is commonly used in financial journal articles (e.g. Deloof,

2003; Lazaridis and Tryfonidis, 2006). Lately, the streams have come together, possibly

because more interest is shown towards the management of financial supply chains (Hofmann

and Kotzab, 2010; Blackman and Holland, 2006). Table 4 shows results of the three search

for ‘cash conversion cycle’ and ‘cash-to-cash’ (or ‘cash to cash’) from Scopus database in article title, abstract and keywords.

Table 4. Scopus search for ‘cash conversion cycle’ and ‘cash-to-cash’

Time             ‘cash conversion cycle’           ‘cash-to-cash’

June 2014                          55           22

February 2014              48                     21

September 2013              41                      21

The results shown in Table 4 do not include duplicates; therefore the number of articles

discussing working capital management has increased by 15 articles between September

2013 and June 2014. The number of articles where cash conversation cycle is used has

increased much more than the number of articles where cash-to-cash is used. The research

group in which the author belongs, for example, solely uses the term cash conversion cycle,

and three of the last seven new journal papers were written by members of this group, which

could possibly affect search results.

Basically, the ideas of the definitions of CCC are similar even though they range from a

general statement to detailed descriptions. The definitions include for example the following aspects.

“The cash conversion cycle, by reflecting the net time interval between actual cash

expenditures on a firm's purchase of productive resources and the ultimate recovery of

cash receipts from product sales, establishes the period of time required to convert a

dollar of cash disbursements back into a dollar of cash inflow from a firm's regular

course of operations.” (Richards and Laughlin, 1980, p. 34)

“Cash-to-cash is a composite metric describing the average days required to turn a dollar

invested in raw material into a dollar collected from a customer” (Stewart, 1995, p.43)

“The cash conversion cycle, which mirrors the operating cycle, measures the interval

between the time cash expenditures are made to purchase inventory for use in the

production process and the time funds are received from the sales of the finished

products. This time internal is measured in days and is equal to the net of the average age

of the inventory plus the average collection period minus the average of accounts

payable” (Schilling, 1996, p. 4-5)

“The Cash Conversion Cycle (CCC) is an additive measure of the number of days funds

are committed to inventories and receivables less the number of days payments are

deferred to suppliers.” (Shin and Soenen, 1998, p. 38)

The development of CCC was directed to two branches after it was published in 1980. The

first branch of development improved the accuracy of measure. Gentry et al. (1990)

developed the weighted cash conversion cycle (WCCC), which takes into account the amount

of funds committed at each step of the cycle. The weights are calculated by dividing the

amount of cash tied up in each component by the final value of the product. The WCCC

includes both the number of days and the amount of funds that is tied up at each stage of the

cash cycle. Furthermore, Viskari et al (2012b) introduced the advanced cash conversion cycle

(ACCC) for controlling the amount and cost of working capital. It refines and extends the

concept of WCCC. The ACCC is designed for the operational level, and it observes the

capital tied up in the operating cycle of an order from raw material purchases to the

remittance of the customer for the delivered product. Both WCCC and ACCC are based on

the internal data of a company or the value chain of a product, for example. Evaluation and

validation of these models is difficult because data used in these models is not available in a

database or in public.

The other branch of development criticizes the denominators for the three components of

CCC. Shin and Soenen (1998) introduced the net trade cycle (NTC) where all three

components of CCC are expressed as a percentage of sales. They stated that the denominators

are all different, making the addition not particularly useful. Farris and Hutchison (2003)

suggest that inventories and accounts payable should be divided by the cost of goods sold and

accounts receivable by net sales. When the interest in the management of financial supply

chains increased, a new problem emerged: the company’s cost of goods sold is not shown in

the profit and loss account. At the moment, the cost of sales method is only absolutely

mandatory according to US GAAP (Generally Accepted Accounting Principles in US). The

International Financial Reporting Standards (IFRS) allow the use of the cost of sales method

and the nature of expense method which does not reallocate expenses among functions within

the company. Hofmann and Kotzab (2010) introduced the calculation of CCC based on the

definition of Farris and Hutchison (2003), but actually they use the definition of Shin and

Soenen (1998). In the footnotes, Hofmann and Kotzab (2010, p. 308) state: “Many companies

use the cost of goods sold instead of net sales when calculating DPO and DIO. The article

uses net sales across each working capital component to allow a balanced comparison across

each C2C cycle element and provides true comparisons between industries”. Soenen (1993)

notes that the net trade cycle increases the uniformity and simplicity of calculation.

Losbichler et al. (2008) point out that revenue data is usually more readily available than the

cost of goods sold. It is not unambiguous to define the value of COGS for a company that

follows the nature of expense method in its financial reporting. When the value of sales is

used as the denominator instead of the COGS, the cycle time of inventories and accounts

payable is shorter for most companies, because normally the value of sales is higher than the

value of the COGS.