Cash Conversion Cycle Calculation — Microsoft Excel
In this article, we will walk you through the core concept of cash conversion cycle calculation and we also have a glance of how it is important for identifying cash flow and receiving patterns. We basically calculate the cash that we actually received from customers against our product or service and than we count how much cash we make and how much product we sold out at the time of inventory.
Cash Conversion Cycle Calculation
Cash conversion cycle or operating cycle or working capital cycle measures how long cash is tied up in inventory sold and cash collected from customers. Working capital reflects the investment required to support the cycle.
The cash conversion cycle should be compared to its historic data and peer companies operating in the same industry and conducted on a trend. The shorter the cash conversion cycle, the better the company is at selling inventories and recovering
cash while paying suppliers.
Formula:
To get the result of the cash conversion cycle, we must calculate the listed below.
- Debtors turnover ratio and debtors collection period.
- Creditors turnover ratio and creditors payment period.
- Inventory turnover ratio and inventory conversion period.
Let’s take an example to understand this better.
- Get the average of opening and closing values of debtors, creditors and inventory to calculate all three turnover ratios.
The above figure, shows where we have the results of avergaes of debtors, creditors and inventory 25, 32.5 and 26 respectively.
2. Get the turnover ratio, as shown in the figure below, on the basis of averages and sales turnover, as we did in section C in Financial Ratios.
As we can see in the above figure, debtors turnover ratio, creditors turnover ratio and inventory turnover ratio are 4, 3.08 and 3.85, respectively.
3. Now we will calculate the debtors collection period, creditors payment period and
inventory conversion period, as shown in the figure below.
As we can see in the above figure, Debtors Collection Period (DSO), Creditors Payment Period (DPO) and Inventory Conversion Period (DIO) are 91, 119 and 95,
respectively.
4. Then, we will get the result of cash conversion cycle, which is CCC = DSO + DIO – DPO, as shown in the figure below.
As we can see in the figure, the cash conversion cycle is 67 days as per our example. It means that the company takes 67 days to complete an operating cycle or working
capital cycle.
Determination of Working Capital
Several factors influence the total investment in working capital. The determination of working capital
Nature and Size of Business
The first and most significant determination is the nature and size of the business. A service company requires less
investment in working capital even if the size of business is large, whereas a trading company requires more investment, even if it is smaller in size than a service company. On the other hand, a manufacturing company requires more investment than all other types of companies.
Position of Business Cycle or Business Cycle Fluctuations
Working capital requirements increase during festive seasons or when large orders are received, like during festivals. We will need more stock at every level of business for these times to expand production or trading. It means the volume
of working capital is directly proportionate to the volume of production.
Manufacturing Process
If production takes longer, it means we need a
greater amount of working capital.
Market Conditions
If there is a higher competition in the market, products need to be sold cheaper to increase sales, so we need to sell larger amounts of
inventories. In this case, we need to make enough working capital for large production.
Growth and Expansion of Business
We need more working capital to grow and expand our business.
Credit Policy
If company gets a small credit period, it means they need
more cash to purchase, so more working capital investment is required. On the other hand, if a company gives a small credit period, less working capital
investment is required.
Dividend Policy
A shortage of working capital often becomes a reason for reducing or skipping a cash dividend. On the other hand, a strong position may justify continuing dividend payments. Dividend policy also affects working capital. Payment of dividends causes outflow of cash, while retained profits act as a source of working capital.
Tax Level
It is also dependent on the rates of tax and tax provisions.
Other Determinations
- Lack of coordination between different departments or even in the same department leads to the need of higher working capital. As accounting and finance professionals, we must bridge the gap and ensure coordination.
- Transportation of goods or raw materials can cause higher working capital due to lack of good infrastructure as it increases the cost of
transportation. - A good import-export policy can give an advantage and lower the working capital requirements, whereas the lack of a good policy increases working capital requirements.
Sources of Working Capital Finance
Every business needs working capital but they need working capital. And every business cannot afford 100% equity, so they need financing, there several ways to
get finance.
Financing Without Loans
- Trade Credit (Supplier Credit )
Get credit period from vendors.
2. Advance from Customers
Get advance from customers for their orders.
3. Accrued Expenses
Clear outstanding payments that are accrued but not due, for example, rent, utility bills and salaries, later.
4. Provisions
Make provisions for some expenses or duties so that we
can use this as working capital till they are payable, for example,
bonus and taxes.
Short Term Loans and Credit Facilities
- Cash Credit
This is a secured loan where a company must give security against inventory and receivables. The bank provides this cash credit facility for a certain limit, which is evaluated based on security. The interest for cash credit is charged on the daily balance and not on the entire amount.
2. Overdraft Facility
It is an agreement between bank and lender by which a current account holder can withdraw a little more than the balance in their account.
3. Loan
Banks provide short-term loans or working capital loan to
lenders as per their requirements and credit score.
4. Purchasing and Bill Discounting
Banks give advances against
receivables. The seller draws a bill of exchange for the buyer of goods on credit. The bank purchases the bill on demand and deducts its
charges and commission.
5. Pre-Shipment and Post Shipment Financing
Banks pay the advance
for pre shipment and post shipment financing to exporters against their export sale.
Non Fund Based Facilities
- Letter of Credit, Bank Guarantee and Buyers Credit
LC, BG and buyers credit ensure timely delivery of goods as they create trust between the importer and the exporter.
Long Term Financing
- Equity
Investment by VC or public investment.
2. Bank Loans for Business
Term Loan, Loan Against Property, Loans against securities.
Conclusion
Finally, we will understanding the fundamental principles of cash conversion and along with that we also learn how we can calculate this by using applicable formulas and reach out to better results. When we receive payments from customers or clients against our products we sold out and this cash we convert into many other important business decisions that help us to grow.
