Introduction to Corporate Finance

18: Cash Conversion, Inventory and Receivables Management

If Reese Industries could reduce from eight days to three days the amount of time it takes to receive,
process and collect payments after they are mailed by its customers, then it would reduce its average
collection period from 45 days to 40 days (37 + 3). This would shorten the cash conversion time line by five
days (8 – 3), and thus reduce the amount of resources that Reese Industries has invested in operations. For
Reese Industries, a five-day reduction in the average collection period would reduce the resources invested in
the cash conversion cycle by $68.5 million [$5 billion × (5 ÷ 365)].

18 -1c SHORTENING THE CASH CONVERSION CYCLE

In order to maximise shareholder value, the financial manager should manage the company’s short-term

activities in a way that shortens the cash conversion cycle. This will enable the company to operate with

minimum cash investment. The company can find alternative uses for any cash that it is not using to fund

the cash conversion cycle – for example, using the cash to pursue more productive long-term investments,

using it to pay down expensive long-term financing or distributing it to the owners as dividends.

FIGURE 18.1 TIME LINE FOR THE OPERATING AND CASH CONVERSION CYCLES FOR REESE INDUSTRIES

Reese Industries has an operating cycle of 115 days, and because it takes on average 40 days to pay its accounts payable,
the company’s cash conversion cycle is 75 days.

Purchase raw

materials on account

Collect accounts

receivable

Average

payment

period

75 days

Cash conversion cycle

Payment mailed

70 days 37 days 8 days

Average age of inventory Average collection period

Sell finished

goods on account

Time = 0 115 days

Operating cycle

Time

40 days

example