Cash purchase or produce inventory, and hold it for

Cash
conversion cycle is a process in which a company use a working capital cycle
that they purchase or produce inventory, and hold it for a period of time and
then sell it to receive cash. The cash goes from the supplier to make
inventory, goes back to the company as account receivable, and turn back to
cash. The company has to be aware of what inventories sells quickly so
inventory is not just sitting unsold.

In order for an
investor to evaluate a company, it must know the company’s liquidity and
working capital management. A working capital calculates the company’s
productivity, capability and financial standpoint for a short period of time. It
helps the investor predict the risk of bankruptcy of the company. Liquidity
determines how fast an asset can be converted to cash without altering the price
of the asset, generate enough cash to sustain its everyday demands, and pay for
goods and services. Liquidity of a company can be measured by:

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1.     Current ratio- this can be calculated dividing current liabilities by
current assets it is a straight forward way to calculate liquidity.

2.      Acid test ratio- calculated by
subtracting inventories from current assets and divide by current liabilities;
the formula does not include inventories and current assets (excluding cash).

3.      Cash ratio- calculated by adding
cash equivalents and short term investments divided by current liabilities; it
is a more reasonable formula for calculating liquidity.       

These various
ways of measuring liquidity do not measure its approximation to cash. Current,
cash ratio and acid tests are easy to calculate; they target liquidity of
current liabilities one moment in time. Cash conversion cycle is specifically
focused on accounts payable, it makes up for the areas acid tests, cash ratio and
current ratio do not measure. The period of time in which current assets are
converted to cash is not accounted for when using current ratios and acid ratio
and cash ratio tests. This can give false information or affect the company
negatively. Cash conversion cycle can provide an in-depth result of liquidity
when combined with current ratio and acid test rather than being used alone
which can give a false report as well. Cash conversion cycle reduces net operating
assets, therefore boosting the return on net operating assets which improves
the revenue and returns of stock of the company. It creates a great face value
for the company.

Cash conversion cycle formula: Inventory conversion
period (average inventory/ (cost of goods sold/365)) + Average collection
period (average accounts receivable/ (net sales/365))- Payables deferral period
(average accounts payable/ (costs of goods sold/365). Inventory conversion
period calculates the amount of days in which the company turns inventory into
cash/accounts receivable. Average collection period calculates the amount of
days in which the company rounds up on sales cash. Payables deferral
period calculates the number of days the company can delay the payments of
their account payable while maintaining a good relationship with vendors. This minimizes
the cash conversion cycle

Delaying payments can
ruin a relationship and trust with a vendor. The company manager can select a
deferred payment to prolong due date of payment. A deferred payment option with
a prolonged due date exhibits a better liquidity because it minimizes the
company’s cash conversion cycle. Although cash conversion cycle is a very
important measure of liquidity in a company; delayed payments can cause a
strain on the chain of suppliers because some vendors need the upfront payment
to maintain their working capital specifically small suppliers. This can lead
to the vendors increasing prices, loss of vendors and suppliers. It can cause a
strain on the employees of the company because they have direct interaction
with the vendors and feel the direct stress and pressure from the vendors which
can lead to unethical behavior and conflict. Extended payment comes with a
cost, most vendors will offer a lower price with an early payment to motivate companies
to pay one time, and a fee for late payments so in the long run the company is
spending more. Some vendors do not offer discounts, but will have fees for late
payments. Extended payments can actually affect the company’s cash conversion
cycle by making it lower, giving the company a better liquidity. Amazon is an example
of a company that delays payments to vendors, they can do so because they are a
big and powerful company. It is advisable as a company not to consider the
vendor as an enemy, but to communicate clearly, build a great relationship and
make sure both parties benefit. A company should be disciplined in terms of
following the arrangements agreed upon between the company and the vendor. Be considerate
of the supplier’s needs. Keep in mind long term relationships and not get
consumed by immediate results. Still apply great customer service and ethical behavior
when dealing with a vendor.

 

Apple has its own
retail stores all over the world, so the consumers are paying them directly. Therefore,
apple does not have a long average collection period. Apple has fewer products-
phones, laptop, I-pad, etc. Which brings them a faster inventory turnover
because it has a streamline portfolio. Apple products sell very quickly and at
a large volume due to its popularity, this is an advantage for Apple because
their vendors will be willing to accommodate deals with them. Samsung sells
most of its inventories though department stores, distributors, and retail
shops. there a very few Samsung individual retail shops. these distributors
also have to sell other consumers, leaving Samsung with a longer average
collection period because the vendors need a credit period. Samsung has a very
wide range of products- phones, laptops, refrigerators, washing machines, TV’s,
computer, cameras, cooking appliances, air conditioners, etc. They need
different manufactures for these products, making it harder for them to
negotiate deals with several vendors. Samsung has a slower inventory turnover.

 

Small companies tend
to focus on emergencies and problems in the company rather than the account
payables and account receivables. They are reactive, instead of being proactive.

They lack working capital management, and usually up against the wall financially.

This can be due to the fact that a small companies has less employees than a
large company, so chances are some employees have multiple jobs in the company,
they are not able to focus on a single task. Small companies tend to have a
lower cash conversion cycles because they have higher current assets, high
short short debts and a cash flow that goes up and down due to the inflation
and growth rates in the industry. Companies that have a large cash flow tend to
have higher cash conversion cycles. High cash conversion cycles results in a low
return on invested capitals due to a significant increase of assets and
invested capital.

Cash conversion cycle
becomes negative when the payables deferral period is longer than the normal operating
cycle. As a result, investors would not fund the company with cash to finance
the operating cycle, the company will own the cash flow during this period of
the cash conversion cycle. after the cash conversion cycle period is over, the company
must pay the cash flow bill created, also known as invisible credit.

A study was done to
determine the relationship between cash conversion cycle and profitability. Although
cash conversion cycle measures the company ability to manage its operating
cycle and current assets, it does not necessarily impact the profitability of
the company. They are both have an opposite relationship. Return of assets
measures the profitability of the company.  A few studies concluded claim cash conversion
cycle can increase the value of the company and increase the profitability of
the company if the period of cash conversion cycle is well managed. The return
of assets can be affected by the average collection period. The less time spent
on customer’s credit of sales, the higher increase of profitability of the company.

Some studies show the higher the cash conversion cycle, the less the company’s
profitability. And the lower the conversion cash cycle, the better the company’s
profitability.

 A low cash conversion cycle is best
recommended as it shows a company working capital is well managed enough to buy
and inventory, collect the resulting receivables ahead of the the due date of
the inventory purchased. A well managed working capital keeps the company at an
enriched level signifying that the sales ratio will improve. A reduction in
working capital is necessary for the reinforcement of future sales, resulting
in an increase of annual free cash flow including in the future years. It allows
the managers of the company to reduce possession of pointless assets like marketable
securities and cash, reduces the amount of short term debts needed by the
company to provide liquidity, an increase of the company’s net cash flow.

 

 

 

 

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