Let’s imagine a company we called Nile, Inc. Nile is a vegetable retailer who has the following metrics –
Cost of Goods Sold (COGS) = $365
Average inventory = $10 (they have low levels of inventory in general)
Sales = $1095
Accounts Receivable = $30
Accounts Payable = $30
Based on these metrics, we can do the following calculations –
Inventory turnover = COGS/average inventory = 36.5
Nile, Inc. turns over its inventory 36.5 times a year. That’s a good sign. The more turns means the more efficient its inventory buying process.
DSI or Day Sales Inventory = (1/Inventory turnover) *365 = 10 days
This means it takes Nile, Inc. 10 days to convert its stockpile of inventory into cash. If Nile turned its inventory slower, it would take longer. Since it is a vegetable retailer, we can imagine it requires to turn fresh produce quickly.
Receivables Collection Period = Accounts Receivable / (Sales/365) = 10 days
This means it takes Nile 10 days to collect its receivables. This is common in businesses that work with consumers as credit card money comes in within 5-10 days.
Payable Period = Accounts Payable / (Sales/365) = 10 days
Nile takes 10 days to pay its suppliers – a short payable period for most businesses. But, this is on account of Nile’s size. As Nile grows, it is can extract longer payable periods (e.g. 100 days).
So, if we now think of what this looks like –
So, Nile takes 20 days to convert inventory to cash – 10 days to convert it from inventory to a sale and 10 more days to convert the sale to a cash. However, since it takes 10 days to pay suppliers, we can now reduce the 20 day number to 10 days.
10 days is Nile’s Cash Conversion Cycle. The Cash conversion cycle is an important idea since this means Nile requires 10 days worth of “working capital” (Current Assets – Current Liabilities on the balance sheet) to keep its business solvent. Since, at any given point, Nile will require enough cash to support 10 days of operations, if it doesn’t have the cash itself, it will always need access to a revolving line of credit that can make sure the business runs. Reducing the cash conversion cycle is an attractive prospect for most small businesses as it means less dependence on external capital. It also reduces the working capital requirements of the firm.
Amazon is an example of a firm that does an outstanding job with working capital management. Amazon’s cash conversion cycle (CCC) is actually negative. This means Amazon receives cash very quickly, turns over its inventory quickly and takes much longer to pay its suppliers. So, the business is practically throwing off cash. Negative CCCs work well for growing businesses. However, when a business stops growing, these cycles can be painful since it means you have to pay your suppliers greater amounts than you make.
Aside from a thank you to all our Finance professors, I’d like to also give a thank you shout out to Prof Aswath Damodaran from NYU Stern. Prof Damodaran has some fantastic resources available online for different kinds of finance problems.