The Importance of Cash

Defining the Cash Flow Cycle

The cash flow cycle is also called the "cash conversion cycle" (CCC). In management accounting, the CCC measures how long a firm will be deprived of cash if it increases its investment in resources to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.

Cash Conversion Cycle

The cash conversion cycle is the time frame between a firm's cash disbursement and cash collection. However, the CCC cannot be directly observed in cash flows because these are also influenced by investment and financing activities; it must be derived from a statement of financial position or balance sheet data associated with the firm's operations.

Retail

Although the term "cash conversion cycle" technically applies to a firm in any industry, the equation is formulated to apply specifically to a retailer. Since a retailer's operations consist of buying and selling inventory, the equation models the time between the following:

1. Disbursing cash to satisfy the accounts payable created by the purchase of inventory and
   
   
2. Collecting cash to satisfy the accounts receivable generated by that sale.

The CCC must be calculated by tracing a change in cash through its effect on receivables, inventory, payables, and finally, back to cash. Thus, the term cash conversion cycle and the observation that these four accounts "articulate" with one another.

The equation describes a firm that buys and sells on account and is written to accommodate such a firm. For a cash-only firm, the equation would only need data from sales operations (e.g., inventory changes) because disbursing cash would be directly measurable as purchasing inventory, and collecting cash would be directly measurable as selling inventory.

However, for a firm that buys and sells on account, Increases and decreases in inventory do not occasion cash flows but accounting vehicles (receivables and payables, respectively); increases and decreases in cash will remove these accounting vehicles (receivables and payables, respectively) from the books.