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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