Liquidity management: the cash conversion cycle
How to measure the time gap between cash inflows and outflows
We're finally off again.
After three months of Covid-19 lockdown, Italian businesses have finally reopened their doors.
As Italy is slowly getting used to a new normality, enterprises will have to deal with the economic consequences of the lockdown and with the drop in consumption. One of the major issues will be liquidity management.
We've already talked about the financing sources for SMEs in the past articles. Here we will focus on a specific indicator that can help companies in cashflow management: the cash conversion cycle.
Cash conversion cycle: what is it?
The cash conversion cycle (CCC) measures the average time a business takes to convert the production inputs into cash receipts. In other words, it measures the time gap between the firm's disbursing and collecting cash.
To be noted that the selling moment does not always coincide with cashing in. Except for business-to-consumer (B2C) companies, which directly sell the products to the end -consumers, in most cases payment will be made 30, 60, or even 90 days after the effective sale of the product.
However, inflows delays can be offset by outflows delays: suppliers are generally paid after the company has come into possession of the production inputs.
Together with these two variables, it should be also taken into account the average number of days that the company holds its inventory before selling it. The formula for calculating the cash conversion cycle will therefore be as follows:
Days Sales Outstanding (DSO) + Days Inventory Oustanding (DIO) - Days Payable Outstanding (DPO)
What is the average cash conversion cycle?
The duration of the cash conversion cycle varies according to the type of enterprise. For instance, a retail company takes less time to collect credit than a business upstream of the supply chain. To check whether the duration of a company's cash conversion cycle is on average, the company's CCC values should be therefore compared with the average CCC times of the sector to which it belongs.
That could be quite complicated. Although a company can easily calculate its own CCC, it may encounter difficulties in acquiring the sector values. An alternative is to check the indicator quality of the monetary cycle included among the liquidity indicators in the credit risk section of s-peek's Extended12M reports: if the indicator is green, the times are in line with the industry average. Negative values indicate that the duration of the cash conversion cycle is even shorter than the average.
What if the indicator light is orange or red?
In this case, a review of cash flow management policies is recommended. Problems can arise from the delay of cash collection times but also from the payment deadlines imposed by suppliers, which often offer higher discounts for short-due payments.
A review of working capital management can enhance the company's liquidity resources and contain its financial needs. With the restart of business activities, the analysis of the cash conversion cycle can no longer be delayed.
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