For a business to operate it must purchase and pay for inventory and services from suppliers, convert these into a product, and then sell and receive payment for the product from customers. The cash conversion cycle is the number of days between paying the supplier for the goods and services and receiving payment from the customer.
The cash conversion cycle is summarized in the diagram below:
The business buys the inventory from suppliers and holds it as inventory and work in process for a number of days (inventory days), before it sells the finished product to account customers.
In terms of cash, the business obtains account terms from its suppliers and pays after a period of time (accounts payable days). It also gives account terms to its customers and receives payment from them after an additional period of time (accounts receivable days). The difference between the time the business pays the suppliers and the time it receives payment from customers, is referred to as the cash conversion cycle, shown in green above.
How to Calculate Cash Conversion Cycle Example
Suppose a business purchases inventory from suppliers and is given account terms of 30 days. The business holds inventory and work in process for 90 days, and then sells to customers on 60 day account terms. This is summarized in the diagram below.
The cash conversion cycle formula can be used to calculated the cash cycle as follows:
Cash conversion cycle = Inventory days + Accounts receivable days - Accounts payable days Cash conversion cycle = 90 + 60 - 30 = 120 days
Improving Cash Flow
It was seen in the above example that the business must fund the inventory and services purchased from suppliers for a period of 120 days until it receives payment from its customers. The larger the cash conversion cycle, the greater the period over which this cash requirement must be provided. If for example the business cannot obtain account terms from its suppliers, allows its inventory levels to increase to 120 days, and has to extend credit to customers to 75 days, then the cash conversion cycle increases as follows:
Cash conversion cycle = Inventory days + Accounts receivable days - Accounts payable days Cash conversion cycle = 120 + 75 - 0 =195 days
The business must now finance the cash requirement for 195 days instead of the previous 120 days.
Clearly management of inventory, accounts receivable, and accounts payable levels (referred to as working capital management) is an important aspect of ensuring that there is adequate cash flow to operate the business.
If the business operates its inventory more efficiently reducing the holding time to 60 days, improves its debt collection procedures and reduces its accounts receivable to 45 days, and negotiates to extend its account facilities with suppliers to 45 days, then the cash conversion cycle will fall as follows:
Cash conversion cycle = Inventory days + Accounts receivable days - Accounts payable days Cash conversion cycle = 60 + 45 - 45 = 60 days
The business now only has to finance the cash requirement to fund the working capital cash conversion cycle for a period of 60 days.
In summary, the shorter the cash conversion cycle, the quicker purchases are converted back to cash and the less the business has to depend on external funding.
Cash Required to Fund Working Capital
While the above discussion shows the number of days in the cash conversion cycle, the actual cash requirements depend on the level of trade conducted by the business.
Consider a business which projects revenue of 200,000 at a gross margin percentage of 45%. Using this information, the cost of sales is calculated as 200,000 x (1 – 45%) = 110,000.
Suppose the financial projections also show accounts receivable days of 60, inventory days of 90, and accounts payable days of 30.
Using this information the level of working capital can be calculated as follows:
Accounts receivable = Accounts receivable days x Revenue/365 Accounts receivable = 60 x 200,000 / 365 Accounts receivable = 32,877 Inventory = Inventory days x Cost of sales/365 Inventory = 90 x 110,000 / 365 Inventory = 27,123 Accounts payable = Accounts payable days x Cost of sales/365 Accounts payable = 30 x 110,000 / 365 Accounts payable = 9,041
The cash required to fund this working capital can now be calculated.
Cash required = Accounts receivable + Inventory - Accounts payable Cash required = 32,877 + 27,123 - 9041 Cash required = 50,959
At this level of trade, the business will need to find funding of 50,959 in order to finance the cash conversion cycle.
Expressing the Cash Cycle in Terms of Revenue
In the above calculations the level of working capital depends on using the number of accounts receivable days based on revenue and the number of inventory and accounts payable days based on cost of sales.
In order to simplify the calculation, it is possible to express inventory and accounts payable levels in terms of a number of days revenue instead of the number of days cost of sales. The calculations are as follows:
Inventory days (based on revenue) = Inventory days x Cost of sales/Revenue Since Cost of sales/Revenue = (1 - Gross margin %) Inventory days (based on revenue) = Inventory days x (1 - Gross margin %) Inventory days (based on revenue) = 90 x (1 - 45%) = 50 Inventory days (based on revenue) = 50 days revenue Accounts payable (based on revenue) = Accounts payable days x (1 - Gross margin %) Accounts payable (based on revenue) = 30 x (1 - 45%) Accounts payable (based on revenue) = 17 days revenue
Based on days revenue the cash conversion cycle can now be restated as follows.
Cash conversion cycle = Inventory days + Accounts receivable days - Accounts payable days Cash conversion cycle = 50 + 60 - 17 Cash conversion cycle = 93 revenue days
Based on revenue of 200,000 our cash conversion cycle is 93 days revenue and the cash requirement is 93 x 200,000/365 = 50,959 which is the same as calculated above.
What this means is that the business shown above needs 93 times the daily revenue to finance the working capital needs generated by that revenue. In this example the daily revenue is 200,000 / 365 = 548, and the finance required is 548 x 93 = 50,959.
In a badly controlled business the cash conversion cycle might increase causing the revenue days to increase to say 145 days, now the same business with the same level of revenue needs 548 x 145 = 79,460 to finance its working capital requirements.
Likewise, if the business is operated efficiently and the cash conversion cycle is reduced, the revenue days will reduce to say 60 days, and the business now needs only 548 x 60 = 32,880 to finance its working capital.
Revenue Growth and Working Capital
It is also interesting to note that higher levels of revenue need more cash to finance working capital. If the business projected rapid expansion to a revenue of 400,000 a year, then the daily revenue increases to 400,000 / 365 = 1,096, and the working capital cash requirement increases to 1,096 x 93 = 101,928. This explains why without good working capital control, together with adequate profitability and external financing in place, a business can start to over-trade, run out of cash, and fail.
Cash Conversion Cycle and Financial Projections Template
When using the financial projections template assumptions are made regarding the inventory days, accounts receivable days, and the accounts payable days. Setting the value of each automatically adjusts the cash conversion cycle for the projection.
Use the assumptions from your financial projection template to calculate the cash cycle. In order to correctly determine the need to borrow additional funds to finance working capital requirements, the cash cycle should be adjusted in order to bring it into line with standards in your industry.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.