Question

Choose a business and discuss the cash cycle and how it works in your view. What are the usual opportunities in the cash cycle for improvements or problems?

an example:

In a used car business we need to be mindful of cash flow because sales are uneven and costs can be fairly constant. Revenue is based on our inventory of cars to be sold and the general environment for buying, pricing and selling that inventory.

Fixed costs are usually fairly low - utilities, insurance, and possibly rent. Variable costs are paid when we make a sale so for this analysis are relevant to operations only from the point of impact on net profits.

We can operate on a cash only basis but that will limit our sales so we usually need to align with a bank or operation to provide financing unless we wish to take on that risk and operational complexity.

If we outsource our financing then cash collection becomes much easier but we will lose an opportunity for a source of profit.

There is a little more to this but I hope you all can glean what I am looking for in this discussion.

Answer 1

The Cash Cycle measures how long we need to finance Inventory and Receivables. Understanding and managing the cash conversion cycle is vital for all organisations.

Let’s take an example, Yummy Chocolates, our business is buying and selling chocolate. We also hold inventories of chocolate. The more cash we invest into chocolate, the larger our inventories, and the smaller our cash balances.

Successful working capital management includes identifying an appropriate safe level of inventory to minimise stock outs, as well as managing supplier, customer and internal operational relationships.

To do that, we need some key numbers to compare and discuss

How long would our inventory last if we didn’t replace it? This is our investment in inventory, measured in days.Stock outs can lead to delays, loss of revenue, additional costs and loss of goodwill. Clearly, we want to avoid stock outs.

Suppose we have the following financial information:

Profit and loss extracts ($m)
Revenue	90
Cost of sales	50

   

Balance sheet extracts ($m)
Inventory	17.5
Receivables	4.5
Payables	5.5

Inventory days=Inventory /cost of sales x 365

=17.5/50*365= 128 days

This seems a very high level of inventory, likely to be too high

RECEIVABLES DAYS: The credit period we’re giving our customers.

Receivables days is:
Receivables / revenue x 365 = 4.5/ 90 x 365 = 18 days

Operating Cycle is the total investment in inventory and receivables, in days.

operating cycle is:inventory days + receivables days = 128 + 18 = 146 days

The operating cycle quantifies our total investment in inventory and receivables, which we need to fund. The operating cycle is offset, and partly funded by, our suppliers. Our net position is measured by the CCC.

Cash conversion Cycle(CCC)This is the number of days it takes us to convert cash outflows into cash inflows.

A formula for payables days is:
Payables / cost of sales x 365 = 5.5 / 50 x 365 = 40 days

A formula for the CCC is:
Inventory days + receivables days less payables days = 128 + 18 - 40 = 106 days

This seems to be a high and we should consider reducing its inventory levels.

Assuming we’ve now successfully reduced inventory by $10.5m, and all other amounts are unchanged, recalculate the CCC.

Is the CCC better or worse now?

New cash conversion cycle
Inventory is now £7 (17.5 – 10.5).
Inventory days:
= 7 / 50x 365
= 51 days

CCC:
= 51 + 18 - 40
= 29 days

In this situation we’ve also investigated and identified that the reduction in inventory appears safe and appropriate.
Based on this information, the reduction in CCC is indeed a good thing.