Your Money: What the Cash Conversion Cycle Says About a Business

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The rule of inference, the higher the DP, the better the efficiency.

The effectiveness of working capital can be assessed using the cash conversion cycle (CCC). Let us examine the calculation of CCC with its inference rule.

Hypothetical illustration
Assume the following figures (amount in Rs crore) for Abhijit Dipankar Phanindra Ltd (ADP) for its last financial year: Current assets 1,200; Trade receivables 600; inventories 400; cash and cash equivalents 100; other current assets 100; current liabilities 800; commercial debts 300; accrued charges 100; current portion of long-term debt 150; short-term bank loan 150; other current liabilities 100; 2000 turnover; cost of goods sold 1,200; daily sales 5.48 (2000/365 days); daily cost of goods sold 3.29 (1200/365 days).

Currency conversion cycle (CCC)
It is the excess of a company’s operating cycle over days payable. The operating cycle is the sum of days of receivables and days of inventory. While the operating cycle reflects the days taken by a business to recover its funds tied up in inventory and receivables, CCC reveals the adjusted payable days to recover the money that goes out into a business’s operations.

Inventory Days (DSI)
It is the number of days a business stores inventory and is calculated by dividing inventory by a business’s daily cost of goods sold (CGS). For ADP, it is 122 days (inventories of Rs 400 crore divided by daily CGS of Rs 3.29 crore) for the current year. The fewer days inventory, the better the efficiency of a company’s inventory management. If ADP’s DSI was 150 days the previous year, then the company has improved its inventory management efficiency for the current year.

Days to receive (DSO)
This is the number of days a business takes to collect its debts. It is calculated by dividing the trade receivables by the daily sales of a business. For ADP, it is 109 days (trade receivables of Rs 600 crore divided by daily sales of Rs 5.48 crore) for the current year. Decrease the average collection time, the better the efficiency of a company’s receivables management. If ADP’s receivables days were 120 days in the previous year, then the company has improved the efficiency of its receivables management for the current year.

Days to pay (DD)
It reveals the number of days taken by a company to pay its contributions. It is calculated by dividing trade payables and accrued liabilities by the daily cost of goods sold (CGS). For ADP, DP is 122 days. This indicates that ADP takes 122 days to pay its suppliers. If the company’s PD was 140 days the previous year, then it has become ineffective in managing its debts in the current year.

The rule of inference, the higher the DP, the better the efficiency.

Currency conversion cycle (CCC)
The CCC for ADP is 109 days (122-day DSI plus 109-day DSO minus 122-day PD) for the current year. It was 130 days (150-day DSI plus 120-day DSO minus 140-day PD) the previous year. It took 109 days for the company to recover one rupee that was withdrawn from operations last year, compared to 130 days for the same the year before. As a result, the efficiency of the company’s working capital has improved during the current year.

The writer is Associate Professor of Finance at XLRI – Xavier School of Management, Jamshedpur

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