Chapter 15 Working Capital Management 47915-4 THE CASH CONVERSION C YCLE
All! rms follow a “working capital cycle” in which they purchase or produce inven-
tory, hold it for a time, and then sell it and receive cash. This process is similar to the
Yankee peddler’s trips, and it is known as the cash conversion cycle (CCC).
15-4a Calculating the Targeted CCC
Assume that Great Fashions Inc. (GFI) is a start-up business that buys ladies’ golf
out! ts from a manufacturer in China and sells them through pro shops at high-end
golf clubs in the United States, Canada, and Mexico. The company’s business plan
calls for it to purchase $100,000 of merchandise at the start of each month and have
the merchandise sold within 60 days. The company will have 40 days to pay its sup-
pliers, and it will give its customers 60 days to pay for their purchases. GFI expects
to just break even during its! rst few years; so its monthly sales will be $100,000, the
same as its purchases. Any funds required to support operations will be obtained
from the bank, and those loans must be repaid as soon as cash is available.
This information can be used to calculate GFI’s cash conversion cycle, which
nets out the three time periods described below:^3
- Inventory conversion period. For GFI, this is the 60 days it takes to sell the
merchandise.^4 - Average collection period (ACP). This is the length of time customers are
given to pay for goods following a sale. The ACP is also called the days’ sales
outstanding (DSO). GFI’s business plan calls for an ACP of 60 days, which is
consistent with its 60-day credit terms. - Payables deferral period. This is the length of time GFI’s suppliers give GFI to
pay for its purchases (40 days in our example).
On Day 1, GFI buys merchandise and expects to sell the goods and thus convert
them to accounts receivable in 60 days. It should take another 60 days to collect the
receivables, making a total of 120 days between receiving merchandise and collect-
ing cash. However, GFI is able to defer its own payments for 40 days.
We combine these three periods to! nd the planned cash conversion cycle,
shown here as an equation and in Figure 15-3 as a picture.
Inventory Average Payables Cash
conversion # collection " deferral! conversion 15-1
period period period cycle
60 # 60 " 40! 80 days
Although GFI must pay $100,000 to its suppliers after 40 days, it will not
receive any cash until 60! 60 " 120 days into the cycle. Therefore, it will have to
borrow the $100,000 cost of the merchandise from its bank on Day 40, and it will
not be able to repay the loan until it collects on Day 120. Thus, for 120 # 40 " 80
days—which is the cash conversion cycle (CCC)—it will owe the bank $100,000
and will be paying interest on this debt. The shorter the cash conversion cycle the
better because that will lower interest charges.
Note that if GFI could sell goods faster, collect receivables faster, or defer its
payables longer without hurting sales or increasing operating costs, its CCC would
Cash Conversion Cycle
(CCC)
The length of time funds
are tied up in working
capital or the length of
time between paying for
working capital and
collecting cash from the
sale of the working
capital.Cash Conversion Cycle
(CCC)
The length of time funds
are tied up in working
capital or the length of
time between paying for
working capital and
collecting cash from the
sale of the working
capital.Inventory Conversion
Period
The average time required
to convert raw materials
into finished goods and
then to sell them.Inventory Conversion
Period
The average time required
to convert raw materials
into finished goods and
then to sell them.
Average Collection
Period (ACP)
The average length of time
required to convert the
firm’s receivables into
cash, that is, to collect
cash following a sale.Average Collection
Period (ACP)
The average length of time
required to convert the
firm’s receivables into
cash, that is, to collect
cash following a sale.
Payables Deferral
Period
The average length of time
between the purchase of
materials and labor and
the payment of cash for
them.Payables Deferral
Period
The average length of time
between the purchase of
materials and labor and
the payment of cash for
them.(^3) See Verlyn D. Richards and Eugene J. Laughlin, “A Cash Conversion Cycle Approach to Liquidity Analysis,”
Financial Management, Spring 1980, pp. 32–38.
(^4) If GFI were a manufacturer, the inventory conversion period would be the time required to convert raw
materials into! nished goods and then to sell those goods.