The cash conversion cycle measures the time period required to convert resources into cash. The intent behind the measurement is to determine how long it takes for funds paid to buy resources to be converted into cash by selling the resulting goods and being paid by customers. The factors used to derive the cash conversion cycle are as follows:
- The average time required to pay supplier invoices
- The average time required to convert raw materials into finished goods
- The average time required to collect receivables from customers
The resulting cash conversion cycle formula is:
Of these elements of the cycle, the one most amenable to significant change is the days of inventory outstanding. Receivables figures tend to vary little, while payables payment terms are dictated by existing contracts with suppliers. Consequently, an astute management team will focus its attention on shrinking the investment in inventory.
The cash conversion cycle is typically used as part of an analysis of how the investment in working capital can be reduced. This can result in a number of operational and policy decisions, such as:
- Outsource production, to avoid an investment in inventory
- Install a just-in-time production system, to reduce the inventory investment
- Cancel poorly selling products, thereby eliminating the associated amount of supporting inventory
- Lengthen delivery times, so that the amount of finished goods kept on hand can be reduced
- Tighten the credit policy, to reduce billings to customers less likely to pay on time
- Alter the collection procedures to enforce more rapid customer contacts regarding overdue accounts
- Negotiate with suppliers to lengthen payment terms
A short conversion cycle is considered highly desirable, since it means that a business can be operated with a reduced amount of cash. A company with a shorter conversion cycle than its peer group probably has reached this point due to a continual review of the entire process over a long period of time. At a minimum, a responsible manager may want to track the conversion cycle on a trend line, and take action whenever the cycle indicates that it is taking longer to convert invested funds back into cash.
The cycle is also closely monitored in smaller organizations that have minimal amounts of equity or debt funding. These businesses have so little excess cash that they must be mindful of how their cash is being used. This is a particular problem for nonprofit entities, since they usually have small cash reserves.