Calculating the Cash Flow Cycle

Cash flow cycle = # days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.


Learning Objective

  • Calculate a company's cash flow cycle

Key Points

  • Cash flow cycle = Inventory conversion period + Receivables conversion period – Payables conversion period.
  • Inventory conversion period = Avg. Inventory / (COGS / 365); Receivables conversion period= Avg. Accounts Receivable / (Credit Sales / 365); Payables conversion period = Avg. Accounts Payable / (Purchases / 365).
  • There are five important intervals, referred to as conversion cycles (or conversion periods).
  • Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales.

Key Terms

  • Credit Sales: Credit Sales are all sales made on credit.

Cash Flow Cycle

The cash flow cycle is also called cash conversion cycle (CCC).

CCC=# days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.

= Inventory conversion period + Receivables conversion period – Payables conversion period

Inventory conversion period = Avg. Inventory / (COGS / 365)

Receivables conversion period = Avg. Accounts Receivable / (Credit Sales / 365)

Payables conversion period = Avg. Accounts Payable / (Purchases / 365)

There are five important intervals, referred to as conversion cycles (or conversion periods):

  • The Cash Conversion Cycle emerges as interval C→D (i.e., disbursing cash→collecting cash).
  • The payables conversion period (or "Days payables outstanding") emerges as interval A→C (i.e., owing cash→disbursing cash)
  • The operating cycle emerges as interval A→D (i.e., owing cash→collecting cash)
  • The inventory conversion period or "Days inventory outstanding" emerges as interval A→B (i.e., owing cash→being owed cash)
  • The receivables conversion period (or "Days sales outstanding") emerges as interval B→D (i.e., being owed cash→collecting cash)
Knowledge of any three of these conversion cycles permits derivation of the fourth (leaving aside the operating cycle, which is just the sum of the inventory conversion period and the receivables conversion period.)

Hence, interval {C → D}=interval {A → B}+interval {B → D}–interval {A → C}

In calculating each of these three constituent conversion cycles, we use the equation TIME =LEVEL/RATE (since each interval roughly equals the TIME needed for its LEVEL to be achieved at its corresponding RATE).

We estimate its LEVEL "during the period in question" as the average of its levels in the two balance sheets that surround the period: (Lt1+Lt2)/2.

To estimate its RATE, we note that Accounts Receivable grows only when revenue is accrued; and Inventory shrinks and Accounts Payable grows by an amount equal to the COGS expense (in the long run, since COGS actually accrues sometime after the inventory delivery, when the customers acquire it).

  • Inventory conversion period: Rate = COGS, since this is the item that (eventually) shrinks inventory.
  • Receivables conversion period: Rate = revenue, since this is the item that can grow receivables (sales).
  • Payables conversion period: Rate = [inventory increase + COGS], since these are the items for the period that can increase "trade accounts payables" (i.e., the ones that grew its inventory).

Aims of CCC

Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales. We can change our standard of payment of credit purchase or getting cash from our debtors on the basis of reports of cash conversion cycle. If it tells good cash liquidity position, we can maintain our past credit policies. Its aim is also to study cash flow of business. Cash flow statement and cash conversion cycle study will be helpful for cash flow analysis.