Do you really know how long your business ties up its cash?
Would you like a tool that will help you make the operational changes to drive your cash flow faster?
Relying on static financial ratios of liquidity can be problematic for a company with slow receivables turnover and/or those companies selling product that requires a long conversion time from inventory. Cash and assets that can be quickly converted to cash are the lifeblood of a company. This paper alerts you to the pitfalls of relying solely on traditional measures of liquidity. We recommend you use a measurement tool that captures the impact of the time needed to convert current assets such as receivables and inventory into cash.
A standard measure of liquidity is the Current ratio. This ratio is defined as Current Assets divided by Current Liabilities. It is computed from static numbers, that is, amounts reported on the financial statements at a point in time. Accountants, analysts, creditors and others rely on this ratio to assess a firm’s liquidity. While there are general guidelines for what this number should be, there are no clearly defined methods for determining whether a firm’s current ratio is ‘better’ or ‘worse’. This is problematic for assessing the true liquidity of a company. While it has some relevance to understanding a company’s fiscal health, it can be easily manipulated by managing the timing of payments to vendors and may not be relevant when comparing a company’s financial performance to industry peers or a benchmark. In a worst-case scenario, you may have a false sense of near-term liquidity when relying only on the traditional measures such as the Current Ratio.
A solution to this limited approach for measuring liquidity can be found by adding a calculation of the Cash Conversion Cycle (CCC), which provides a dynamic view of a company’s cash cycle from procuring product through collecting receivables from customers. Besides providing an important complementary statistic to traditional ways of measuring a firm’s liquidity, it helps identify underlying operational factors that determine cash flow. The Cash Conversion Cycle computes the number of days for the cash cycle, thereby incorporating an operational component to the calculation of a company’s liquidity. The CCC is calculated as:
CCC = Days Inventory Outstanding + Days Receivable Outstanding – Days Payable Outstanding
Days Inventory Outstanding measures how long it takes for a company to convert its inventory to sales.
Days Receivable Outstanding measures how long it takes for a company to collect on sales.
Days Payable Outstanding measures the days it takes the company to pay its vendors.
The cash conversion Cycle will be shorter when a company can more quickly transform inventory into sales, collect on accounts receivable for those sales, and delay the payments of vendors (without harming supplier relationships. A shorter cycle also means there is a higher return on operating assets, less need for financing, and higher profitability. The CCC indicates the efficiency and the effectiveness of management and operations. Managers and staff can easily identify the effect that rework, bottlenecks in production, or other delays in creating a sellable product have on Days Inventory Outstanding. Consistently delivering quality throughout a company’s processes raises customer satisfaction, lessens the likelihood of delays in account receivable collection and makes for a high performing organization.
The CCC is a useful metric to add to your company’s toolkit of Key Performance Indicators. Ongoing assessment of a liquidity measurement such as the Cash Conversion Cycle can materially improve the likelihood of delivering on the firm’s unique value proposition.
© Harn & Associates, PLLC | November 2013
Corey Cagle, Sharon Campbell, and Keith Jones, “Analyzing Liquidity Using the Cash Conversion Cycle”, Journal of Accountancy, May 2013
Eugene Brigham, Phillip Daves, Intermediate Financial Management, 11th Edition, Southwestern Cengage Learning, pp. 797-803