In management accounting

Management accounting

Management accounting or managerial accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control...

, the Cash Conversion Cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk

Liquidity risk

In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...

 entailed by growth. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable.

Definition

CCC	=	# days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.
	=	Inventory conversion period	+	Receivables conversion period	–	Payables conversion period
	=	Avg. Inventory COGS Cost of goods sold Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...  / 365	+	Avg. Accounts Receivable Receivables Receivables may refer to the amount due from individuals and companies. Receivables are claims that are expected to be collected in cash. These are frequently classified as:...   Credit Sales / 365	–	Avg. Accounts Payable Accounts payable Accounts payable is a file or account sub-ledger that records amounts that a person or company owes to suppliers, but has not paid yet , sometimes referred as trade payables. When an invoice is received, it is added to the file, and then removed when it is paid...   COGS Cost of goods sold Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...  / 365

Derivation

Cashflows insufficient. The term "cash conversion cycle" refers to the timespan between a firm's disbursing and collecting cash. However, the CCC cannot be directly observed in cashflows, because these are also influenced by investment and financing activities; it must be derived from Statement of Financial Position data associated with the firm's operations.

Equation describes retailer. Although the term "cash conversion cycle" technically applies to a firm in any industry, the equation is generically formulated to apply specifically to a retailer. Since a retailer's operations consist in buying and selling inventory, the equation models the time between

(1) disbursing cash to satisfy the accounts payable created by purchase of inventory, and

(2) collecting cash to satisfy the accounts receivable generated by that sale.

Equation describes a firm that buys & sells on account. Also, the equation is written to accommodate a firm that buys and sells on account. For a cash-only firm, the equation would only need data from sales operations (e.g. changes in inventory), because disbursing cash would be directly measurable as purchase of inventory, and collecting cash would be directly measurable as sale of inventory. However, no such 1:1 correspondence exists for a firm that buys and sells on account: Increases and decreases in inventory do not occasion cashflows but accounting vehicles (receivables and payables, respectively); increases and decreases in cash will remove these accounting vehicles (receivables and payables, respectively) from the books. Thus, the CCC must be calculated by tracing a change in cash through its effect upon receivables, inventory, payables, and finally back to cash—thus, the term cash conversion cycle, and the observation that these four accounts "articulate" with one another.

{| class="wikitable"

|-
! Label
! Transaction
! Accounting (use different accounting vehicles if the transactions occur in a different order)
|-
| A
|
Suppliers (agree to) deliver inventory

→Firm owes $X cash (debt) to suppliers

|

• Operations (increasing inventory by $X)

→Create accounting vehicle (increasing accounts payable by $X)

|-
| B
|
Customers (agree to) acquire that inventory

→Firm is owed $Y cash (credit) from customers

|

• Operations (decreasing inventory by $Y)

→Create accounting vehicle (booking "COGS

Cost of goods sold

Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...

" expense of $Y; accruing revenue and increasing accounts receivable of $Y)

|-
| C
|
Firm disburses $X cash to suppliers

→Firm removes its debts to its suppliers

|

• Cashflows (decreasing cash by $X)

→Remove accounting vehicle (decreasing accounts payable by $X)

|-
| D
|
Firm collects $Y cash from customers

→Firm removes its credit from its customers.

|

• Cashflows (increasing cash by $Y)

→Remove accounting vehicle (decreasing accounts receivable by $Y.)

|}

Taking these four transactions in pairs, analysts draw attention to five important intervals, referred to as conversion cycles (or conversion periods):

• the Cash Conversion Cycle emerges as interval C→D (i.e. disbursing cash→collecting cash).
• the payables conversion period (or "Days payables outstanding") emerges as interval A→C (i.e. owing cash→disbursing cash)
• the operating cycle emerges as interval A→D (i.e. owing cash→collecting cash)
• the inventory conversion period or "Days inventory outstanding" emerges as interval A→B (i.e. owing cash→being owed cash)
• the receivables conversion period (or "Days sales outstanding") emerges as interval B→D (i.e.being owed cash→collecting cash

Knowledge of any three of these conversion cycles permits derivation of the fourth (leaving aside the operating cycle, which is just the sum of the inventory conversion period and the receivables conversion period.)

Hence,

{| style="width:75%; "height=50px"

|-
! style="text-align:left;" |interval {C → D}
! style="text-align:center;" |=
! style="text-align:center;" |interval {A → B}
! align="left" width="40px"|+
! style="text-align:center;" |interval {B → D}
! align="left" width="40px"|–
! style="text-align:center;" |interval {A → C}
|-
! style="text-align:left;" |CCC (in days)
! style="text-align:center;" |=
! style="text-align:center;" |Inventory conversion period
! align="left" width="40px"|+
! style="text-align:center;" |Receivables conversion period
! align="left" width="40px"|–
! style="text-align:center;" |Payables conversion period
|}

In calculating each of these three constituent Conversion Cycles, we use the equation TIME =LEVEL/RATE (since each interval roughly equals the TIME needed for its LEVEL to be achieved at its corresponding RATE).

• We estimate its LEVEL "during the period in question" as the average of its levels in the two balance-sheets that surround the period: (L_t1+L_t2)/2.
• To estimate its RATE, we note that Accounts Receivable grows only when revenue is accrued; and Inventory shrinks and Accounts Payable grows by an amount equal to the COGS
  Cost of goods sold
  Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
  
   expense (in the long run, since COGS actually accrues sometime after the inventory delivery, when the customers acquire it).
• Payables conversion period: Rate = [inventory increase + COGS
  Cost of goods sold
  Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
  
  ], since these are the items for the period that can increase "trade accounts payables," i.e. the ones that grew its inventory.

NOTICE that we make an exception when calculating this interval: although we use a period average for the LEVEL of inventory, we also consider any increase in inventory as contributing to its RATE of change. This is because the purpose of the CCC is to measure the effects of inventory growth on cash outlays. If inventory grew during the period, we want to know about it.

• Inventory conversion period: Rate = COGS
  Cost of goods sold
  Cost of goods sold refers to the inventory costs of those goods a business has sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out , or average cost...
  
  , since this is the item that (eventually) shrinks inventory.
• Receivables conversion period: Rate = revenue
  Revenue
  In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....
  
  , since this is the item that can grow receivables (sales).

Aims of CCC

Our aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and credit sales. We can change our standard of payment of credit purchase or getting cash from our debtors on the basis of reports of cash conversion cycle. If it tells good cash liquidity position, we can maintain our past credit policies. Its also aim is to study cash flow of business. Cash flow statement and cash conversion cycle study will be helpful for cash flow analysis. http://www.svtuition.org/2011/11/how-to-calculate-cash-conversion-cycle.html

See also

• Working capital analysis
  Working capital
  Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is...
  
  
• Days Sales Outstanding
  Days Sales Outstanding
  In accountancy, Days Sales Outstanding is a calculation used by a company to estimate their average collection period. A low number of days indicates that the company collects its outstanding receivables quickly. Typically, Days sales outstanding is calculated monthly...
  
  
• Days Payable Outstanding
• Days In Inventory

External links

• Measuring the Cash Conversion Cycle in an International Supply Chain
• Working Capital Management and Short-Term Planning