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What is the Cash Conversion Cycle (CCC)
The Cash Conversion Cycle (CCC) measures how efficiently a company manages its cash flow. It represents the time taken for a company to convert its investments in inventory and other resources into cash inflows from sales. A lower CCC is generally better, as it indicates the company can generate cash quickly and efficiently, allowing for more capital to be used in new investments.
How is the Cash Conversion Cycle calculated?
The CCC is calculated by adding the following components:
Days of Inventory on Hand (DOH): Time it takes for a company to sell its inventory.
Days Sales Outstanding (DSO): Time it takes for the company to collect payments from its customers.
Days Payables Outstanding (DPO): Time it takes for the company to pay its suppliers.
The formula to calculate CCC is:
CCC = DOH +DSO −DPO
What are the advantages of a low Cash Conversion Cycle (CCC)?
A low CCC is beneficial because:
Cash Flow Efficiency: The company can quickly convert investments into cash and reinvest that cash in new opportunities.
Less Working Capital: A lower CCC means less capital is tied up in working capital, allowing the company to use its resources more efficiently.
Avoids Cash Flow Problems: Shorter CCC reduces the risk of cash flow problems and enhances liquidity.
What are the disadvantages of a high Cash Conversion Cycle (CCC)?
A high CCC can be problematic because:
Slow Cash Conversion: The company takes longer to convert its investments into cash, potentially leading to liquidity issues.
Increased Working Capital: More capital is tied up in inventory and receivables, which could limit the company’s ability to pursue new opportunities.
Cash Flow Problems: Prolonged delays in converting investments into cash can lead to operational difficulties and financial stress.
How can a company reduce its Cash Conversion Cycle?
A company can reduce its CCC by:
Reducing Inventories: Decreasing the amount of raw materials or finished goods can free up cash, but it may risk production delays or inability to meet customer demand.
Reducing Receivables: Tightening credit policies or shortening payment terms may reduce DSO, but it could also lead to lost sales.
Increasing Payables: Extending the time to pay suppliers (DPO) can help manage cash flow, but it may strain supplier relationships.
How do you calculate the EAR of supplier financing?
1+(a/(1-a))^(365/(c-b))-1
a = percent discount
b = days until discount expires
c = days until full payment is due
What is an example of how to calculate EAR of supplier financing?
A supplier offers 2/10 net 30 terms (2% discount if paid within 10 days, full payment due in 30 days). The bank interest rate is 8%.
The financing period is 30 - 10 = 20 days.
Using the EAR formula:
The EAR of 44.6% is significantly higher than the bank’s 8%, so borrowing from the bank is the better option.
How do Cash Conversion Cycles vary by industry?
CCC varies significantly across industries due to differing business models and operational needs:
Pharmaceutical companies: Long CCCs because they maintain high-margin inventories to meet unexpected demand surges.
Airlines: Short CCCs as most sales are prepaid, and they do not keep large inventories.
