Financial Accounting: An Integrated Statements Approach, 2nd Edition

Apple Dell Hewlett- Sun

Computer Inc. Gateway Packard Microsystems

Number of days’ sales in:

Receivables 34 30 28 45 75

Inventory 5 4 17 50 26

Accounts payable (79) (74) (52) (70) (63)

Cash conversion cycle (40) (40) (7) 25 38

Chapter 13 Statement of Cash Flows 597

purchase of inventory on account followed by the account payment, after

which the item is sold and the account collected. In each step, a current ac-

count is involved: inventory, accounts payable, and accounts receivable.

These three balances can be translated into days of sales and used to mea-

sure how well a company efficiently manages noncash working capital. This

measure is termed the cash conversion cycle, which is calculated as follows:

Cash Conversion Number of Days’ Sales in Receivables 

Cycle Number of Days’ Sales in Inventory 

(in days) Number of Days’ Sales in Accounts Payable

Where,

Number of days’ sales Average accounts receivable

in accounts receivable

=

Average daily net sales

Number of days’ sales Average inventory

in inventory

=

Average daily cost of merchandise (goods) sold

Number of days’ sales Average accounts payable

in accounts payable

=

Average daily cost of merchandise (goods) sold

The average account balance in the numerator is determined by adding the begin-

ning and ending balances and dividing by two. The average in the denominator is

determined by dividing the sales or cost of merchandise sold by 365 days.

One way to generate cash from operations is to reduce the amount of noncash cur-

rent assets and increase the level of current liabilities. The more positive the cash con-

version cycle, the less efficient is the firm’s operations from a cash flow perspective.

The smaller the cash conversion cycle, the leaner are the working capital requirements

for a given level of operations, thus releasing cash for other purposes. Negative cash

conversion cycles indicate a highly efficient use of noncash working capital.

To illustrate the cash conversion cycle, the following information was determined

from recent annual reports for selected companies in the computer industry:

As can be seen from the table, Dell,Gateway, and Appleall have negative cash

conversion cycles. For all three companies, their superior inventory management poli-

cies (low number of days’ sales in inventory) explain this performance. Both Sun

Microsystem’s and Hewlett-Packard’s accounts receivable and inventory appear high

for the industry indicating that these companies inefficiently use cash to finance cus-

tomers and inventory.

Free Cash Flow

Working capital efficiency explains how well a firm uses its working capital, but it

does not indicate how much cash is actually being generated. A valuable tool for eval-

uating the cash flows of a business is free cash flow. Free cash flowis a measure of

operating cash flow available for corporate purposes after providing sufficient fixed

asset additions to maintain current productive capacity and dividends. Free cash flow

can be calculated as follows:

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