CP

584 CHAPTER 16 Working Capital Management

Shortening the Cash Conversion Cycle

Given these data, RTC knows when it starts producing a computer that it will have

to finance the manufacturing costs for a 67-day period. The firm’s goal should be to

shorten its cash conversion cycle as much as possible without hurting operations.

This would increase RTC’s value, because the shorter the cash conversion cycle, the

lower the required net operating working capital, and the higher the resulting free

cash flow.

The cash conversion cycle can be shortened (1) by reducing the inventory con-

version period by processing and selling goods more quickly, (2) by reducing the

receivables collection period by speeding up collections, or (3) by lengthening the

payables deferral period by slowing down the firm’s own payments. To the extent that

these actions can be taken without increasing costs or depressing sales, they should be

carried out.

Benefits

We can illustrate the benefits of shortening the cash conversion cycle by looking again

at Real Time Computer Corporation. Suppose RTC must spend approximately

$197,250 on materials and labor to produce one computer, and it takes about nine

days to produce a computer. Thus, it must invest $197,250/9 
$21,917 for each day’s

production. This investment must be financed for 67 days — the length of the cash

conversion cycle — so the company’s working capital financing needs will be 67 

$21,917 
$1,468,439. If RTC could reduce the cash conversion cycle to 57 days, say,

by deferring payment of its accounts payable an additional 10 days, or by speeding up

either the production process or the collection of its receivables, it could reduce its

working capital financing requirements by $219,170.

Recall that free cash flow (FCF) is equal to NOPAT minus net investments in

operating capital. Therefore, if working capital decreases, FCF increases by that same

amount. RTC’s reduction in its cash conversion cycle would lead to an increase in

FCF of $219,170. Notice also that reducing the cash conversion cycle reduces the

ratio of net operating working capital to sales (NOWC/Sales). If sales stay at the same

level, then the reduction in working capital is simply a one-time cash inflow. However,

if sales are expected to grow, and if the NOWC/Sales ratio remains at its new level,

then less working capital will be required to support the additional sales, leading to an

increase in projected FCF for each future year.

FIGURE 16-1 The Cash Conversion Cycle Model

Finish Goods

and Sell Them

Receive Raw

Materials

Pay Cash for

Purchased

Materials

Collect

Accounts

Receivables

Days

(1)

Inventory

Conversion

Period ( 73 Days)

(2)

Receivables

Collection

Period (24 Days)

(3)

Payables

Deferral

Period ( 30 Days)

(4)

Cash

Conversion

Cycle

(73  24  30 
 67 Days)

Working Capital Management 579