Introduction to Corporate Finance

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To calculate the cash conversion cycle, start with the operating cycle and then subtract the average

payment period (APP) on accounts payable. Here is the formula for the cash conversion cycle:

Eq. 18.1 CCC = OC – APP = AAI + ACP – APP

As Equation 18.1 shows, the cash conversion cycle has three main components: (1) average age of

the inventory; (2) average collection period; and (3) average payment period. It also shows that, by changing

these time periods, a company changes the amount of time its resources are tied up in day-to-day operations.

Again referring to Table 18.1, we can see that the cash conversion cycle for each company is

calculated (in row 10) by subtracting the average payment periods (in row 8) from the operating cycle

(calculated in row 9). Reviewing the CCC values, we see that they have negative CCCs in this example.

This indicates that these companies receive cash inflows before having to make the cash outflows needed

to generate those inflows. This desirable state occurs in part because these companies do not keep

inventory on hand for very long, but their vendors give them several months to settle their payables.

Notice how the components of the cash conversion cycle vary considerably across industries. For

example, the baker has a relatively short collection period of about 18 days, and keeps much less than

one month’s worth of inventory on hand. That shouldn’t be too surprising, given the perishable nature

of the inventory (food) and given that most of the company’s sales are done on a cash basis. Also notice

that the clothing manufacturer’s inventory age is about 90 days, or one season. Again, it should not be a

surprise that a fashion retailer would completely turn over its inventory about once each season. A mobile

telephone manufacturer may see a new model appear only every one to two years, so its inventory of its

non-perishable parts would need to cover the longer period.

These calculations are based on data that would be available in the balance sheets and income

statements of public organisations. Because annual purchases do not appear in published financial

statements, the accounts payable period is found by using cost of sales – an approach commonly used

by external analysts. Because annual purchases are likely to be smaller than the cost of sales, these APPs

may be understated.

example

Reese Industries has annual sales of $5 billion, a cost of goods sold that is 70% of sales, and purchases that

are 60% of cost of goods sold. Reese has an AAI of 70 days, an ACP of 45 days and an APP of 40 days. The

45-day ACP can be broken into 37 days until the customer places the payment in the mail, and an additional

eight days before the funds are available to the company in a spendable form. Thus, Reese’s operating cycle

is 115 days (70 + 45), and its cash conversion cycle is 75 days (70 + 45 – 40). Figure 18.1 presents Reese’s

operating and cash conversion cycles on a time line.

Reese has invested the following resources in its cash conversion cycle, where 0.70 indicates that

sales are 70% of cost of goods sold:

Inventory = ($5 billion × 0.70) × (70/365)

= $671.2 million

+ Accounts receivable = ($5 billion) × (45/365)

= $616.4 million

• Accounts payable = ($5 billion × 0.70
  × 0.60) × (40/365)
  = $230.1 million

= Resources invested = $1,057 million

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thinking cap

question

Why do companies try to shorten

their cash conversion cycles?