by Mark J. O'Donnell
Understanding, measuring, and managing the Cash Conversion Cycle may be one of the most critical metrics available to you. Bonus: it’s easy to compute and very useful. It is important enough to add to your monthly Trends Report (see last month’s article) as a KPI (Key performance indicator)
Consider how cash works its way through your operating cycle with these transactions:
- Purchasing inventory
- Selling inventory
- Collecting accounts receivable
These transactions accumulate in these three balance sheet accounts:
- Inventory (I)
- Accounts payable (AP)
- Accounts receivable (AR)
The sum of these accounts (AR+I-AP) is the dollar amount you have invested in the Cash Conversion Cycle. The amount will change from month to month. Unsurprisingly, the cash balance decreases when the net of these accounts increases and vice versa. This delicate balance is critical to your business’ financial stability.
To compare this tool to other periods and companies, it may be helpful to convert the individual balances from dollars to days, as follows:
- Days in accounts receivable (DAR) = accounts receivable divided by average daily sales.
- Days in accounts payable (DAP) = accounts payable divided by the average daily cost of sales (do not include depreciation or labor)
- Sales in inventory (DI) = inventory divided by the average daily cost of sales.
Use those three daily amounts to compute Cash Conversion Cycle Days = DAR+DI-DAP.
Individually and collectively, accounts receivable and inventory are your business’ most economically sensitive assets. Tracking your Cash Conversion Cycle and the three components over extended periods allows you to understand and learn from the past to predict the future. They are flags that indicate how well current procedures manage these assets and the urgency of management action.
If your company is seasonal or cyclical, you can project your cash flow for the near-term future by analyzing the behavior of each individual Cash Conversion Cycle component by looking at similar prior periods. In addition, the data will help estimate a ‘cushion’ for a recession or black swan event by comparing them to previous recessions or unpredictable severe economic crises.
The current business climate makes maximizing your Cash Conversion Cycle more critical; not only does a slower cycle eat up your liquidity, but if you have a (now higher interest) line of credit every extra day in your Cash Conversion Cycle costs you bank interest.
However, take care about using this data. By its nature, these computations are driven by the relationship between sales and cost of sales. If the gross margins on sales change significantly from prior periods, it will impact the dollar amounts and days (length) of the Cash Conversion Cycle. As a rule of thumb, the lower your margin goes the quicker your Cash Conversion Cycle needs to be.
Next month, in part three, we will cover the best ‘at a glance’ management cover sheet for your monthly financial statements.
We are happy to provide an Excel spreadsheet with examples of the above computations. Just email us at connectwithus@stcpa.com with ‘Cash Conversion Cycle’ in the description.
Mark O’Donnell, CPA, is Partner at Schmersahl Treloar & Co. He can be reached at 314.966.2727.