The Importance of Cash

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

CCC = the number of 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 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 surrounding the period: (Lt1+Lt2)/2.

To estimate its RATE, we note that Accounts Receivable grow only when revenue is accrued; Inventory shrinks, and Accounts Payable grow 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 item 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 their inventory).

Aims of CCC

Our aim in studying the cash conversion cycle and its calculation is to change our policies regarding credit purchases and sales. Based on reports of the cash conversion cycle, we can change our standard of payment for credit purchases or get cash from our debtors. If it shows a good cash liquidity position, we can maintain our past credit policies. The study also aims to study a business's cash flow. A cash flow statement and cash conversion cycle study will be helpful for cash flow analysis.