Working capital and cash conversion cycle – MBA Learnings

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 –

cash conversion cycle, working capital

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.

cash conversion cycle, working capital

As you can see, 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.

0 thoughts on “Working capital and cash conversion cycle – MBA Learnings”

  1. That was a nice overview. I haven’t read any theory but I can follow the argument almost all the way.

    However, in the last paragraph I don’t understand the problems of the negative cash conversion cycle. As I understand it, a negative CCC means that my customers pay me before I have to pay my suppliers. This means that I am always liquid and won’t even need a credit line.
    How can this mean that I have to pay my suppliers more than I make?

    1. Glad to hear, Stian.

      The negative cash conversion cycle makes sense if the company is growing. So, if you made $100 in sales this month, you will likely have to pay your suppliers $90 in cash for what you bought 3 months ago.

      However, if sales are declining, you could be only bringing in $90 this month but will need to pay $100 for the higher sales 3 months ago.

      Does that help?

      1. Right. I’m just thinking from my frame of reference.
        I would be defensive and just hang on to the $100 for three months before paying my supplier. This would be inefficient, of course. I would be having a pile of cash permanently sitting unused.
        Still, I would argue that the problem is that my business is declining and not the negative CCC. :)

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