Why is it correct to use a sales per day/Cost of goods sold per day combination...

Why is it correct to use a sales per day/Cost of goods sold per day combination to calculate CCC when contemplating a change in receivables, inventory, and payables but use cost of goods sold exclusively when contemplating a change in the level of sales?

Expert Solution

Cash conversion cycle measures how fast a firm/ company can convert its cash on hand into even more cash on hand.

CCC= Days of inventory outstanding (DIO) + Days of receivables outstanding (DSO) - Days payable outstanding (DPO)

As DIO, DSO and DPO are turnaround ratios ( measuring speed), it is appropriate that we use a combination of stock and flow to determine the average transition period- i,e, a balance sheet no. ( inventory / payables / receivables) with a no. derived from P & L statement (e.g. Sales per day, Cost of goods sold per day).

For example: DIO = Average inventory/COGS per day

COGS per day provides idea on average cost of goods sold per day and dividing it by average inventory tells us how much days of inventory is held by the company.

As sales per day are derived from sales ( by dividing sales by no. of days in corresponding period), it is not feasible to use this variable. COGS per day is also not suitable as it contradicts matching principle - the revenues of an entire period can't be compared with the cost for a day. COGS is a better metric to contemplate the level of sales for a particular period as both are directly proportional to volumes sold ( assuming the company manufactures one product only) during the period and also meet the requirements of matching principle. More the sales, higher would be required volumes to be sold and manufactured and higher would be the costs of goods sold.

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