Cash Conversion Cycle is a financial metric that attempts to measure the amount of time for which each input dollar is tied up in the inventory and sales process before it is converted to cash through sales. Stated otherwise, conversion cycle is the net amount of time period required to sell inventory,collect receivables and make payments to the suppliers. The metric is calculated using the following formula:
Cash Conversion Cycle: Days of Inventory+ Days of Receivables- Days of Payables
Important to note, it is always undesired for a company to hold cash levels in the inventory levels and within the receivables for a longer period of time as in such event the company will hold less cash in hand and will be unable to pay its creditors on time. Consequently, the company will be unable to obtain the supply at favorable credit terms or the supplier may just not deliver the supply on credit basis. Henceforth, it is always required that the company should have a short cash conversion cycle.
Below we have suggested some of the ways of shortening the cash conversion cycle:
i)Decreasing inventory turnover period
The first step an entity should take is to employ inventory management techniques and reduce its inventory turnover period. It is considerable that a significant portion of working capital is tied up in the inventory levels and opting for inventory optimization technologies cut down the lag time between the cash flow cycle and improve the conversion cycle.
ii) Re-optimizing receivable period
Using the existing relationship with the customers and enticing them to pay their bills early, is another way of reducing the cash conversion cycle. If the customers hold on to their bills for a long time, this will adversely affect the cash flow. Henceforth, an entity can offer them discounts on making early payment in lieu of attaining the benefit of improving the conversion cycle.
Example:
Referring to the above table, we can see that while Company A and Company B are efficiently run, Company B lacks behind Company B because of their inability to collect the receivables in a prudent time period. Therefore, if Company B reduces its receivable period, it will have cash conversion cycle as good as of Company A.
References
Lewis, J. (n.d.). How Can a Company Shorten Its Cash Cycle? Retrieved March 1, 2016, from http://smallbusiness.chron.com/can-company-shorten-its-cash-cycle-37755.html
Nordmeyer, B. (n.d.). Is It Better for a Company to Have a Short or Long Cash Conversion Cycle? Retrieved March 1, 2016, from http://smallbusiness.chron.com/better-company-short-long-cash-conversion-cycle-81944.html
