Introduction to Corporate Finance

18: Cash Conversion, Inventory and Receivables Management

two and generally sells its products for cash – will have a very short operating cycle. In contrast, General

Motors Holden, a car manufacturer, takes several months to convert raw materials into finished products,

which are sold on credit. The operating cycle for such a company may extend to six months or longer.

The operating cycle influences a company’s need for internal or external financing. In general, the

longer a company’s operating cycle, the greater its need for financing. For example, a bakery might pay

its suppliers and its employees using the revenues generated each week. The car manufacturer probably

cannot persuade suppliers and employees to wait several months for payment while the company collects

cash from car sales. Therefore, the car company has a greater need for financing day-to-day operations.

The operating cycle encompasses two major short-term asset categories: inventory and accounts

receivable. To measure the operating cycle, we use two ratios covered in Chapter 2. First, calculate the

average age of inventory (AAI) and the average collection period (ACP). Next, take the sum of these two

items to determine the length of the operating cycle.

Table 18.1 presents example operating cycles for some companies in different industries. Rows 1

to 5 present data available from balance sheets and income statements, and rows 6 to 8 calculate the

time periods (in days) for AAI, ACP, and average payment period (APP), respectively. Using the AAI and

ACP calculated in rows 6 and 7, row 9 shows the OC for each industry. Note that the baker has the

shortest operating cycle, as one would expect because of the perishable nature of food products.

TABLE 18.1 ANNUAL OPERATING CYCLE (OC) AND CASH CONVERSION CYCLE (CCC)

FOR SELECTED COMPANY TYPES

Mobile telephone manufacturer Clothing manufacturer Baker

Data ($ millions)

(1) Sales $99,870 $4,979 $24,075

(2) Cost of sales $53,857 $2,080 $14,437

(3) A/P $19,060 $ 747 $ 2,916

(4) A/R $27,353 $ 485 $ 1,179

(5) Inventory $ 2,549 $ 504 $ 110

Time periods (days)

(6) AAI {[5] ÷ [(2) ÷ 365]} 17.3 88.4 2.8

(7) ACP {[4] ÷ [(1) ÷ 365]} 100.0 35.6 17.9

(8) APP {[3] ÷ [(2) ÷ 365]} 129.2 131.1 73.7

(9) OC [(6) + (7)] 117.2 124.0 20.7

(10) CCC [(9) – (8)] –11.9 –7.1 –53.1

18 -1b CASH CONVERSION CYCLE

The elapsed time between the points at which a company pays for raw materials and at which it receives

payment for finished goods is called the cash conversion cycle (CCC). The difference between the operating

cycle and the cash conversion cycle indicates the amount of time for which suppliers are  willing to

extend credit. Most companies obtain a significant amount of their financing through trade credit, as

represented by accounts payable. By taking advantage of trade credit, a company reduces the amount of

financing it needs from other sources to make it through the operating cycle.

operating cycle (OC)

Measurement of the time that

elapses from the company’s

receipt of raw materials

to begin production to its

collection of cash from the sale

of the finished product

cash conversion cycle (CCC)

The elapsed time between the

points at which a company

pays for raw materials and at

which it receives payment

for finished goods

Jackie Sturm, Director of

Finance for Technology and

Manufacturing, Intel Corp.

‘Inventory loses value

every day you hold it.’

See the entire interview on

the CourseMate website.

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