[MUSIC PLAYING] This is Dr. Bob Nolley. And then the last lesson, we talked about the components that need to be managed in working capital management. In this lesson, we will look at the relationship between them and the cash conversion cycle.
We mentioned the importance of sufficient cash on hand and how that relates to accounts receivable, inventory, and short-term borrowing. We can measure the current state impact of all of these by measuring a business's cash conversion cycle. The cash conversion cycle is the length of time it takes a company to convert cash spent into cash received.
Let's see what this looks like. The cash conversion cycle begins when inventory is received. During the inventory cycle, goods move from raw materials to work in progress to finished goods that are eventually sold.
At the time of sale, the business may still not have received its cash because the sale is on credit. So we add on to the cycle the number of days it takes to receive payment. Together, these days inventory plus the receivable days equal the operating cycle.
Now if the business could take advantage of trade credit, it will not expend cash when it gets inventory, but rather when they pay their supplier later. This period of time is the number of payable days. When we subtract this from the operating cycle, we have the cash conversion cycle. And this is the number of days from the time a business pays its creditor to the day that a customer pays their bill.
The cash conversion cycle can be expressed in the following formula. The number of days it takes a company to convert cash spent into cash is equal to the inventory conversion period, plus the receivables conversion period, minus the payables conversion period.
Let's look at an example. Let's say our company keeps 76 days of sales in inventory. These are spread throughout the various phases of raw materials, work in process, and finished goods. When they look at their accounts receivable, they find that their receivables are paid on the average in 30 days. They look at the accounts payable, the money they own their suppliers, and find they pay in five days.
Their cash conversion cycle, then, is 76 days of inventory plus 30 days of accounts receivable outstanding, minus five days of accounts payable sales. This makes the cash conversion cycle 101 days. After calculating this, they can do some analysis to make improvements, such as perhaps carrying less inventory or not paying their accounts payable as quickly as they do.
The credit policy and amount in accounts receivable is always open to inspection. Some customers pay with cash and others pay late. But on the average, they are paid within 30 days.
Now let's review the key concepts on the importance of cash in the cash conversion cycle. The term cash conversion cycle refers to the time span between a firm's disbursing cash and collecting cash. It involves close management of inventory procurement, accounts receivable, and the credit policy, and how long the company takes to pay its suppliers.
The cash conversion cycle can be estimated as the days sales of and inventory plus the days sales of receivables minus the days sales in accounts payable.
This is Dr. Bob Nolley. And I'll see you in the next month lesson.