Understanding and managing the cash conversion cycle (CCC) is vital for all organisations - effective management can release much-needed cash and boost liquidity.
As a treasurer you are not only responsible for investing cash safely. You also need to fully understand the cash conversion cycle, and its fundamentally important role in operations. In simple terms, the CCC reflects our efficiency in managing inventory (stock), receivables and payables. We’ll start with inventory, as it’s the easiest to visualise.
Let’s take a simple example. Say we all work for Chox Group. Our business is buying and selling chocolate. We also hold inventories of chocolate. We’ll have to pay for the chocolate, of course.
The more cash we invest into chocolate, the larger our inventories, and the smaller our cash balances.
Good management includes holding appropriate levels of working capital, not too much and not too little.
To develop this idea further, let’s define some key concepts.
Successful working capital management (WCM) includes identifying an appropriate safe level of inventory to minimise stock outs, as well as managing supplier, customer and internal operational relationships.
To do that, we need some key numbers to compare and discuss. First, let’s quantify inventory days for Chox Group.
INVENTORY MANAGEMENT TERMS
|How long would our inventory last if we didn’t replace it? This is our investment in inventory, measured in days.
|A situation in which levels of inventory (stock) are too low to meet demand. Stock outs can lead to delays, loss of revenue, additional costs and loss of goodwill. Clearly, we want to avoid stock outs.
We have the following information from Chox Group’s management accounts:
|Profit and loss extracts (£m)
|Cost of sales
|Balance sheet extracts (£m)
A simple formula for inventory days is:
Inventory / cost of sales x 365 = 35 / 100 x 365 = 128 days
This seems a very high level of inventory, likely to be too high. We will return to this.
Continuing to focus on key numbers for now, let’s extend our understanding into the broader operating cycle.
OPERATING CYCLE TERMS
|The credit period we’re giving our customers. Our investment in receivables, in days.
|Our total investment in inventory and receivables, in days.
Now let’s quantify receivables days and the operating cycle for Chox Group.
A formula for receivables days is:
Receivables / revenue x 365 = 9 / 180 x 365 = 18 days
A simple formula for the operating cycle is:
Inventory days + receivables days = 128 + 18 = 146 days
The operating cycle quantifies our total investment in inventory and receivables, which we need to fund. The good news is, the operating cycle is offset, and partly funded by, our suppliers. Our net position is measured by the CCC.
CASH CONVERSION CYCLE TERMS
|The credit period we’re taking from our suppliers. Offsets and funds part of our investment in the operating cycle.
|CASH CONVERSION CYCLE
|This is the number of days it takes us to convert cash outflows into cash inflows.
It is also the amount of liquidity, measured in days, to which we need access.
Let’s quantify the payables days and CCC for Chox Group.
A formula for payables days is:
Payables / cost of sales x 365 = 11 / 100 x 365 = 40 days
CASH CONVERSION CYCLE
A formula for the CCC is:
Inventory days + receivables days less payables days = 128 + 18 - 40 = 106 days
LIMITED INFORMATION HEALTH WARNING
These calculations are a simple starting point for working capital management. In practice, as we will see shortly, we would go into the figures and operational dimensions in much more detail, and refine our analysis. Areas for further detailed investigation will depend on the sector and business model we’re working with, and the findings of our initial review.
But in the absence of more information, we need to work with whatever we’ve got, suitably qualifying our recommendations based on the amount and quality of available data.
TOO MUCH INVENTORY?
Returning to Chox Group briefly, in theory, it should consider reducing its inventory levels.
Before we do that, let’s turn to a real-life case study:
£21m cash release
As a student you learn a lot of theory. When you get to the workplace, you can spend a lot of time working out how to put that theory into practice. This is another set of skills.
Putting theory into practice occurred in a European subsidiary group of a global fast-moving consumer goods brand. The group’s finance team had not been questioned on its working capital practices and, in particular, its inventory management system.
Asking operational teams questions to understand what was happening at a detailed level revealed a potential huge cash-generation opportunity. The inventory levels needed were analysed on a product-by-product basis against forecast demand.
This confirmed a large overinvestment in inventory.
The management team was persuaded there was a cash opportunity and that stock outs would not result from careful reduction in a number of, but not all, product lines.
Coordination with sales, marketing and inventory management teams to reduce inventory levels step by step demonstrated that it was ‘safe’ to do so.
A more active and joined-up inventory management process, aligned more closely to the sales forecast, was put in place.
The result was more than £21m in cash from working capital that year for a £180m turnover group. There were no stock outs. A fantastic result for the business!
Jess Coles FCA AMCT, director, Emerson Nash
YOUR TURN NOW
Remember we previously calculated Chox Group’s CCC as 106 days, and believed inventory levels might be too high. Let’s assume we’ve investigated, and concluded that it would be safe and appropriate to reduce inventory by £21m.
- Assuming we’ve now successfully reduced inventory by £21m, and all other amounts are unchanged, recalculate the CCC.
- Is the CCC better or worse now?
1. New cash conversion cycle
Inventory is now £14m (35 – 21).
= 14 / 100 x 365
= 51 days
= 51 + 18 - 40
= 29 days
2. Is this better?
Yes. In this simplified situation we’ve also investigated and identified that the reduction in inventory appears safe and appropriate.
Based on this information, the reduction in CCC is indeed a good thing.
Author: Doug Williamson
Contributors: With thanks to Jess Coles, Michèle Allman-Ward and John Mardle for their valued suggestions and guidance.
Source: The Treasurer magazine