FMAccounting.com » Cash conversion cycle

Topics Covered In This Heading:Cash Conversion Cycle(CCC)/Daily Working Capital(DWC)Cash Operating Cycle

slang — Tue, 11 Mar 2008 04:42:56 +0000

This heading covers the following topics:

What is Cash Conversion Cycle

Cash Conversion Cycle- Methodology and Computation

Order to Cash Cycle-Definition, Overview and Benefits and Kpa/Kpi

Cash Conversion Cycle- An Ilustration besides using the exhaustion method.

Using Days Inventory Outstanding(DIO) for better stock management.

Cash Operating Cycle/Cash Conversion Cycle/Daily Working capitalAnd The Steps To Improve Cash Flows

Cash Flow Indicates Company’s Health

slang — Sat, 05 Aug 2006 09:33:33 +0000

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In the Edge, Malaysia (3/8/06) there was a very interestingly article pertaining to the importance of cash flow. This is especially useful when it relates to your own personal investment. The keynotes: earnings can be easily manipulated but not cash flow & it is the key to the lock of the company’s health
Read on:
On August 2, at a luncheon talk in Kuala Lumpur on “ Identifying Potential Financial Reporting Abuses” organized by Chartered Financial Analysts (CFA) Malaysia the speaker, the principal of Sanskar Investments, Chicago-based fund manager Jay Taparia shared his insight:

Smart investors look at the cash flow statement of companies first instead of the income statement to understand the actual financial health. There were always cases of companies manipulating their accounts to make their figures “a bit rosier”;
Such manipulation was abetted by loopholes in accounting standards. The Generally Accepted Accounting Principles (GAAP) were more open for manipulation compared to simple cash accounting;
Small business accounting has always been on a cash basis and it is much harder to manipulate;
Income statements are prone to manipulation, as there are multiple ways to account for every line item on income statements;
As for revenue, it could be recognised under three different scenarios – when cash came in the door, when contract signed but no cash received and when probability that contract will be signed is high;
For instance, revenue overstatement could occur via “channel stuffing” where companies place inventory on client sites and booked them as revenue even though the cash was not received.

Interestingly, he further shared his opinion which we should try to appreciate:

As an investor and money manager, he does not use the income statement anymore and he is overly concerned about earnings per share or price-to-earnings ratios;
he preferred to use the cash flow statement as it was relatively the same each time as the corporate cheque book had to be reconciled to cash;
the bottomline is – if we see revenue and net income increase and cash flow from operations decrease, be suspicious about tomfoolery. Cold hard cash never lies.;
Investors would want to have ethical and motivated management whose main objective was to maximise cash flow and thus shareholder value alongside with their own and
Shareholder-friendliness and management who care about how their employees are treated have always paid well to shareholders.

Companies under pressure to manipulate financials are:

High growth (expectation) industries – companies under heavy pressure from competitors and shareholders – high-risk industries (for example technology and biotechnology companies;
Management under fire to short-term results (for example, first net profit, turnaround, new management team, post acquisition);
Managements that stand to gain short-term personal windfalls for “results”;
Companies inordinately dependent on high share price to support continuing operations (ability to get loans, acquisitions); and
In a market of “irrational exuberance” – any company afraid of being left behind.

What is Cash Operating Cycle And Ways To Improve Cash Flows

slang — Wed, 05 Jul 2006 10:53:02 +0000

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Cash operating cycle is a close loop cycle which encompasses the five stages of normal operating business cycle:

(1) The receipt of raw materials from suppliers;
(2) Conversion of the raw materials into work in progress and finally to finished products;
(3) Delivery of goods and billings to the customers/accounts receivable
(4) Collection from the accounts receivable and
(5) From the collections utilized to repay the accounts payable.

Cash Operating cycle is also known as the Operating Business Cycle or Cash Conversion Cycle(depicted in number of days) or Daily Working Capital.(in number of days)

In the Cash Operating Cycle, there are three (3) key components that we should focus upon:

Inventories whether in the form of raw materials, work-in-progress or finished goods
Accounts Receivables or trade debtors,
Accounts payable or the trade creditors

Now, you would have got the idea that the way to improve cash flow is to improve the cash operating cycle or to shorten the gap of this cash operating cycle from the time we received the goods until the time we received money from our accounts receivables and to optimize the time period of payment to our accounts payable.

So what else can we do to improve our enterprise’s cash flows?

To facilitate easy reading, append below a checklist which might give a quick snapshot on how to improve cash flows whether in terms of quantum and/ timing:-

Improving Pricing policy
With more innovative pricing, higher gross profit margin can be achieved and assuming constant cost hence when the money is collected , there is then a larger quantum of “liquid profits”
Attempt to increase Sales Volume
Again, the impact means a higher sales and assuming costs maintained. So,if cash are collected back, then there is a larger quantum of “liquid profits”
Seek deposits or multiple stage payment.
Reduce or manage effectively the business expenses.
With this, cash outflow in terms of payment of goods or services can be smaller hence overall net cash flow can be saved/improved
Manage your cash outflow of capital expenditure by ensuring that the fixed assets are absolutely necessary before incurring it. For a business, there is a need to weigh profitability and cash flow in investment appraisal .Hence, payback basis might be one answer to improve cash flow.
Seek to extend/re-negotiate debt repayment periods & banking facilities.
Defer projects that cannot achieve acceptable cash paybacks.
Defer unnecessary and unproductive capital expenditures
Focus on short or quick payback though profitability level might not be the desirous level. Perhaps, balancing this cash flow with other projects that give higher yields might be more appropriate
Apply for tax installments to the Authority for the payment of any income tax payable
Obtain other sources of financing like bank overdrafts, term loans, debentures, and longer credit terms from suppliers.
Use factoring facility to convert your billings to customers into cash.
Instead of using one lump sum to paid for fixed assets, go for leasing or hire purchase terms to alleviate cash flows problems
Strategically, when the business is expanding drastically and to prevent overtrading or under-capitalized ,it is critical that the shareholder need to put additional money in the form of paid up capital into the business instead of relying on external parties
To improve the cash flow, it is important to review all cash flow projections whether cash inflow or outflows and the ability to PLAN, TIME or MATCH it accordingly. This might “help” to alleviate some challenges posed by cash flow deficit though this is a short term gap measure.
A business cash flow can be improved if top management exercise less risk appetite and are more conservative/ prudent so that cash flow can be conserved within the business instead of aggressive investments into the projects.
Hive off or dispose off unwanted, surplus fixed assets and investments
Plan strategically by looking at innovative means of unlocking cash out of your fixed assets like Sale and Leaseback, creating Real Estate Investment Trust (REIT)
Make your fixed assets investment turn faster. For example, convert it into warehousing facilities to lease out to others or sub-lease your office which has surplus space or share common facilities and leave balance for rental, etc
Minimize your cash dividend payout by issuing script dividend or bonus issue.
Improve your Order to Cash cycle by simplification, standardization and automation leading to error free process flows to enable money to be collected without much disputes
Review any cash term with our creditors, if need be to extend the credit terms by ensuring long term relationship and promise to pay timely
Make prompt payments only when we need to enjoy discount from the creditors.
Use barter to acquire goods and services.
Establish better planning and forecasting to reduce the lead time of inventories from suppliers.
Use the 80/20 rule to manage current assets.
Encourage suppliers to keep stock for us ( just in time concept) or on a consignment basis
Convert raw materials into work-in progress to anticipate for sale to customers. This needs great efforts for both production,sales department and the customers.
Sell off or return obsolete/excess inventory(even with a loss just to generate the cash flow)
Improve systems for billing and collection.
Review credit terms with our customers wherever possible
Be more selective (if possible) when granting credit.
Offer a well structure cash discounts scheme to enable faster collections from customers (add deterrent charges like late payment charges /fees if debtors have not settled on time).

How To Use Days Inventory Outstanding (DIO) for Better Stock Management

slang — Sat, 13 May 2006 08:00:09 +0000

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In my earlier article on working capital management, we noted that days inventory outstanding forms one part of the component of the cash conversion cycle.

This article attempts to explore the further detailed use of DIO in stock management:

If we look at DIO, the formula is simply:
Closing Stock / Cost of Goods Sold or costs of sales X 30 days(month) or X 90 (quarterly)

For analysis purpose, using DIO formula, we can classify the closing stock into various categories namely fast moving, slow moving or non moving stock by pre-defining the range of days.

For example:
Say we have closing stock of $10m, we can use the DIO to re-arrange into :
Fast moving stock – $3m for days below 90 days
Slow moving stock – $3m for days from 91 days to 179 days
Non-moving stock – $4m for days above 180 days

We can then relate this high percentage of non-moving stock in the closing stock to management for emphasizing the importance of better stock management.
Illustrated as a table:

Stock	(X) Closing Stock(Qty)	(Y) Average monthly 3 or 6 months past sales	(Z) Days Inventory Outstanding ( X/Y x 30 days)	Classification/Category
A	150	75	60 days	Fast Moving
B	120	30	120 days	Slow Moving
C	120	10	300 days	Non Moving

Using this DIO, we can align the status of closing stock at a certain period directly to the average monthly sales (in this case in terms of quantity and if multiply by unit cost price = cost of goods sold/cost of sales). Detailed figures extracted this way will assist management to relate the importance of proper stock management which simply and factually stipulated how long the existing closing stock will be consumed.

As a norm, stock management should be looked at from the following areas:

Lead time of stocks purchased
Minimum quantity of stock being purchased
Quality of the stocks
Momentum of the sales ( cost of good sold)

However, in reality, selling personnel will dispute your figures of using past average monthly 3 or 6 months sales figure, insisting to use the forward looking average monthly sales.

Very simply, this can be reinstated by using forecasted sales of the stocks as the figure in the column Z. However, the danger is that if we were to use forecasted figures, we need to ascertain that the figures are accurate other wise, the DIO will be distorted, allowing overstatement of forecasted sales and giving more excuses to bring in more stock.

The financial executive, to avoid the risk of being oversold by selling personnel during the stock management exercise/review should preferably:

Use both past and present average monthly sales figure ( the months of sales depend on the company’s nature of business) for counter checking or as complementary check,
Always be wary of the forecasted sales figure by reviewing the trend and getting positive confirmation and or justification that sales are really moving up not just by one month trend,

How To Compute Cash Conversion Cycle & Example

slang — Fri, 14 Apr 2006 11:21:48 +0000

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There are few ways of computing the components of the Cash Conversion Cycle.

One way is to use the exhaustion method. (Refer to my earlier article on this). This is mainly for internal use for management reporting.

There is another common way which is illustrated as below:
Illustration:
The financials are for Quarterly Results:
DSO= (AR/Sales) x 90 days,
DIO= (INV/COS) x 90 days,
DPO= ( AP/COS) x 90 days,
DSO+DIO-DPO = CCC (Cash Conversion Cycle) or DWC (Daily Working Capital)

Company	Sales	Cost of Sales (COS)	Inventory (INV)	Accounts Receivables (AR)	Accounts Payables ( AP)	DSO	DIO	DPO	CCC
AAA	2,737	2,103	1,166	1,760	1,382	58	50	59	49
BBB	1,441	1,257	724	654	1,075	41	52	77	16
CCC	8,347	7,879	2,223	4,018	1,611	43	25	18	50

Order-To-Cash Cycle: Definition,An Overview, Benefits, KPA and KPI

slang — Thu, 23 Mar 2006 04:16:32 +0000

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The Order to Cash Cycle is a tedious process, which might take about 30% of the total finance costs. If this process is overlooked & becomes inefficient, we can see the following symptoms:

high order-taking time,
high order-fulfillment error rates,
high DSO rates,
high costs of dispute resolutions,
inefficient collection processes.

If this has being resolved the company can build up a competitive advantage by:

reduced receivables and DSO rates hence optimizing cash flows ultimately lead to better working capital management,
help a company improve its debt-to-equity ratio,
reduce its external financing needs and enhance its credit ratings,
enhance customer relationship by higher customer satisfaction to the extent of increasing sales,
freedom to focus on other business-building core capabilities,
lower Order to Cash processing costs.

Order to Cash cycle is a comprehensive process which encompass broadly Order management, invoicing, collections/credit management, cash application and sometimes relating to posting and reporting.

Let’s us try to define the process flow in Order-To-Cash:

Order management: fulfillment of orders from customers, invoicing:the preparation and mailing of invoices, interfacing of billing status, and handling of customer inquiries.

Collections: the account analysis and reporting, outbound calls, collection letters, and coordination with other collection efforts, credit management: the management of credit applications, integration with credit reporting agencies, coordination of credit status, and generation of acceptance and denial letters.

Cash application: including receipt, reconciliation, and application of cash and credit card payments as well as charge-backs.

General Ledger posting and reporting: account review and analysis, write-off preparation, and reporting.

To simplify Order to Cash cycle, we can break it into 2 stages:

order-to-invoice (also called revenue accounting in some industries) and
invoice-to-cash. (The term “order-to-payment” is generally used to describe A/P processes.)

To the financial executive, it is indeed a big challenge as they needs to balance interdepartment boundaries and at the same remain highly sensitive to customer satisfaction metrics because many A/R processes directly touch customers and the revenue they deliver.

We should constantly review the organization’s order-to-cash cycle and compare its performance with industry benchmarks such as percentage of disputes, percentage of non recoverable disputes and days sales outstanding (DSO).

Appended below are some suggestions for the KPA & KPI of the Order to Cash Cycle.

Key Performance Areas	Key Performance Indicators
Order to Invoice
Order management	· % of orders received electronically · % of customer calls taken on initial contact · number of order input error
Order fulfillment	· % of orders delivered to customers in full quantity at the specified time
Invoicing	% of invoice accuracy (i.e., the proportion of invoices with invoice errors relative to the total number of invoices raised); % of invoices requiring manual intervention; and · % of invoices issued electronically
Invoice to Cash
Credit management	· Average credit approval cycle time · % of debt · Targeted DSO · % of targeted disputed debts · % of over dues debtors
Cash Collection	% of cash collected within agreed credit terms (excluding invoices subject to customer query) and · % of cash collected electronically

Cash Conversion Cycle: Methodology and Computation

slang — Sat, 18 Mar 2006 14:43:10 +0000

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In the earlier article on the CCC, we learned about what is CCC, its components and the definition of each component. We shall now turn to how do we compute the various components.

To recap:

Days Sales Outstanding or DSO represents number of days, the Accounts Receivable (AR) is outstanding in term of number of days of sales.

Days Inventory Outstanding or DIO is then represents the number of days, the Inventory is outstanding in term of number of days of Cost of sales.

Days Purchases Outstanding or DPO represents no of days, the ACCOUNTS PAYABLE is outstanding in term of number of days of Purchases

How then can we compute DSO, DIO or DPO?

DSO:-

As this represent the number of days the Accounts Receivable(AR) is outstanding in terms of number of days of sales, we should then count back actual sales each day until the AR is used up. This is called the exhaustion method. This method has the distinct advantage of using actual sales from the period covered by the debts and does not use average or annualized figures.

Suppose our AR at 31.8.05 totalled $3,400,000 we than look at most current August sales which say, has a figure of $2,300,000 (whole month consists of 31 days).

After deducting August sales figure of $2,300,00, what is left is $1,100,000

We then move on to the preceding month which is July’05 say July sales figure is $1,000,000 (whole month consists of 31 days)

What is left is $100,000.

Say June sales figure is $1,000,000(31 days) so $100,000 represents 100,000/1,000,000 x 30 days= 3 DSO

Therefore DSO=31(August)+31(July)+3(part of June)=65 days

So what does this mean? We can say that our August 05 AR are equivalent to all our sales for the last 65 days or we can say that our customers take an average of 65 days to pay or we can also say that whatever we sell tomorrow our customers will pay 65 days later.

Incidentally, this ratio is not affected by the sales value but rather by the payment terms and uncollected overdues and disputes. This is also a telling tale of how efficient our credit management department have fared in their handling of the AR, which includes overdues and disputes.

Similarly to compute DIO and DPO, we should use the above-said same methodology namely the exhaustion method of looking back at costs of goods sold/costs of sales and purchase respectively.

Below, is an example where we can effectively used CCC to our advantage.Within an umbrella of companies of similar business, we can tabulate their respective CCC to gauge their individual performance in managing working capital:-

Company	CCC (Actual) (days)	CCC (Budget) (days)
Company A (Located in X)	120	70
Company B (Located in Y)	180	50
Company C(Located in Z)	60	100
Overall Group	100	60

The Finance Executive can then use this metric to look for a good model performer, perhaps studied their trends/method and apply to those which are weak in managing their CCC.

Cash Conversion Cycle Definition And Overview

slang — Sat, 18 Mar 2006 13:21:08 +0000

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One of the roles of the Chief Financial Officer (CFO) is to establish key performance metrics to assist senior management in gauging the operating performance of the company.

The company’s Cash Conversion Cycle (CCC) or Day Working Capital (DWC) should be included for the following reasons:

it is actually another simple way of looking at working capital management,
by improving CCC, we are able to balance sales growth with the required liquidity to fuel the growth,
with an adverse CCC, survival of the company is at stake particularly when the company is overtrading and recession is around.

Is the CCC a new thing?

No, the CCC’s existence is as old as when accountants were looking into ways of how to reduce or manage the dollars tied up in the working capital of accounts receivable and stocks and optimizing the period owing to accounts payables.

WHAT IS CASH CONVERSION CYCLE?

it represents the amount of time in terms of the number of days between the purchase of materials by a company to produce its end products and the receipt of payment for those end products in the supply chain, it represents the amount of time it takes to turn a dollar spent with a supplier into a dollar received from an end customer. It sounds familiar isn’t it , it is really the operating cycle of a company we are talking about.

Logically, the CCC is so critical as a company with a low CCC is more efficient as it is able to turns its products into cash more efficiently, minimizing the non productive working capital tied up in its business & making more cash available to fund growth and create shareholder value

A basic model of the CCC is as follows :

DSO (Days Sales Outstanding) plus: DIO (Days Inventory Outstanding) less: DPO (Days Purchases Outstanding) = CCC (Cash Conversion Cycle / Day Working Capital)

Let’s try to understand the various definitions involved:

Days Sales Outstanding or DSO represents number of days, the Accounts Receivable (AR) is outstanding in term of number of days of sales.

Days Inventory Outstanding or DIO is then represents the number of days, the Inventory is outstanding in term of number of days of Cost of sales.

Days Purchases Outstanding or DPO represents no of days, the Accounts Payable is outstanding in term of number of days of Purchases

Now, it sounds familiar like it is another ratio of working capital. The difference is that CCC is represented in terms of time or number of days.CCC as a performance metric is indeed a very simple, easy to understand and to use & is a flexible tool for understanding the favourable or adverse changes in working capital management.In fact, surveys conducted by reputable accountancy bodies like CFO Asia.com includes CCC as part of their key performance metric to rank good performers amongst companies in similar industry.

In the next article, we shall discuss the methodology of computing the CCC and ways to improve CCC.