How long does it take your company to convert raw materials to cash collected from customers? The cash conversion cycle is a financial metric that answers this critical question. Here is a closer look into how it is calculated and what it means.
Liquidity vs. Turnover
Liquidity ratios tell whether the company’s current assets are sufficient to cover current liabilities. For example, the current ratio simply compares all current assets and current liabilities. A current ratio below 1 is a red flag that the company may experience cash shortfalls over the coming year.
The more conservative “quick” ratio typically compares only the most liquid current assets (cash, marketable securities and trade receivables) to current liabilities. The optimal level of liquidity varies from industry to industry.
On the other hand, turnover ratios assess how efficiently the company’s resources are being used. These may be computed in terms of the times that the account would turn over in a year, or in terms of the number of days in the account’s operating cycle.
For example, suppose a manufacturer has annual sales of $10 million and an average accounts receivable balance of $1 million. The hypothetical company’s accounts receivable would turn over 10 times per year ($10 million ÷ $1 million) or be collected in 36.5 days ($1 million ÷ $10 million × 365 days). Turnover ratios can also be computed by comparing annual purchases to average inventory or payables.
In general, there is a trade-off between liquidity and turnover. Companies that are sitting on excessive stockpiles of cash, receivables and inventory may be a safe bet for lenders; however, they may not be managing their resources as efficiently as possible. Manufacturers strive to operate “lean,” meaning they generate as much revenue from as few resources as possible.
Best of Both Worlds
Liquidity ratios also tend to treat all current assets the same as cash, even though receivables and inventories are not immediately available to pay off debt. An alternative ratio, known as the cash conversion cycle, accounts for how long it takes to convert current assets to cash and pay off current liabilities. The formula for calculating the cash conversion cycle is a function of three turnover ratios:
Cash Conversion Cycle = Days in Inventory + Days in Receivables – Days in Payables
Returning to the example, suppose the company maintains 90 days in inventory and pays suppliers in 32.5 days. Its cash conversion cycle would be 94 days (90 days in inventory + 36.5 days in receivables – 32.5 days in payables).
The cash conversion cycle evaluates both liquidity and turnover. A positive result indicates the number of days a company must borrow or tie up capital while awaiting payment from customers. A negative result represents the number of days a company has received cash from customers before it must pay its suppliers. You typically want your company’s cash conversion cycle to be as low as possible.
Manufacturing is an asset-intensive industry. Balance sheet metrics, such as liquidity and turnover ratios, can help management understand a company’s financial position. However, no ratio works in isolation. The cash conversion cycle is a robust tool that, when combined with leverage, growth and profitability metrics, can help predict where the company is heading.