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# Cash conversion cycle

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## What is Cash conversion cycle?

The cash conversion cycle is one of the most widely followed liquidity ratio.

As part of Liquidity ratio analysis, similar to the Current ratio and Quick ratio, this financial metric helps in assessing the health of a company.

This learning is going to be a long one since it requires revisiting the previous resources.

This ratio is a function of three important Activity ratios we discussed earlier.

• Receivable Days
• Inventory Days
• Payable Days

## Cash conversion cycle meaning

Cash conversion cycle basically indicates the number of days within which the company receives cash from its investment in Inventories, Receivables after factoring in the payment towards Suppliers.

It shows the time period involved between the purchase of the raw materials and the collection of dues from customers after making payment to suppliers.

## Cash conversion cycle formula

This ratio is clearly dependent on other Activity Ratios which we discussed.

The formula for cash conversion cycle is Receivable Days + Inventory Days – Payable Days

To understand the formula, we need to re-look at Activity Ratio formulas.

### Receivable Days

Receivable days or Days Sales Outstanding (DSO) indicates the number of days within which the company collects the money due from its customers.

The formula for Receivable Days is (Average Receivables/Net Credit Sales) * 365.

Kindly refer to this resource to understand how to calculate Receivable days.

### Inventory Days

Inventory days or Days Inventory on hand (DOH) indicates the number of days it takes for the company to clear the stock.

The formula for Inventory Days is (Average Inventories/COGS) * 365

### Payable days

Lastly, Payable Days or Days Payable Outstanding (DPO) basically indicates the number taken by the company to make the payment towards its Accounts Payable.

The formula for payable days is (Average Accounts Payable/COGS) * 365

Now, let us look at the formula once again.

Cash Conversion Cycle = Receivable Days + Inventory Days – Payable Days

Hence, we need to add Receivable Days to the Inventory Days and then reduce the Payable Days.

This will give us the number of days the cash was blocked with Receivables and in Inventories and the number of days cash was with the company instead of paying to the Accounts Payable.

The sum of all these will give us Cash Conversion Cycle.

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## Cash conversion cycle example

Let us understand the formula using an example.

This is an excerpt of examples discussed as part of Activity Ratios.

Below is the quick summary of the various Days we calculated.

Let us use the formula and calculate the total days for both the companies.

Company A

• Receivable Days = 20 Days
• Inventory Days = 30 Days
• Payable Days = 10 Days
• Cash Conversion Cycle = Receivable Days + Inventory Days –  Payable Days
• = 20 + 30 – 10 = 40 Days

Company B

• Receivable Days = 50 Days
• Inventory Days = 20 Days
• Payable Days = 10 Days
• Cash Conversion Cycle = Receivable Days + Inventory Days –  Payable Days
• = 50 + 20 – 10 = 60 Days

Hence, the cycle for Company A is 40 days while for Company B it is 60 days.

What this indicates is that Company A on average takes 40 days to receive the money back from its investment in Inventories and Receivables but after factoring in the time taken to make the payment towards Accounts Payable.

It is important to note that both companies have the same payable days.

But, Company B has relatively higher receivable days which is making its overall cash conversion cycle relatively higher.

Hence, Company B needs to manage receivable more efficiently.

## Cash conversion cycle using Excel

In our next example, let us calculate the cycle using excel.

### Cash Conversion Cycle Template

2211

46

FREE

The values discussed as part of this example are taken from below resources.

Taken from Receivable Days for Walmart

Receivable Days = (\$5,949/ \$514,405 )*365  = 4.2 Days

Taken from Payable Days for Walmart

Payable Days = (\$46,576/ \$385,301 )*365  = 44.1 Days

Taken from Inventory Days for Walmart

Inventory Days= (\$44,026/ \$385,301 )*365  = 41.7 Days

Below is the summary of various Days for Walmart.

• Receivable Days =  4.2 Days
• Inventory Days = 41.7 Days
• Payable Days = 44.1 Days

Now that we know all the values, let us calculate the cycle for Walmart in excel

Receivable Days + Inventory Days –  Payable Days

4.2 + 41.7 – 44.1 = 1.8 Days

As clearly evident, Walmart has a very low Cash Conversion Cycle of only 2 days.

This means that in the case of Walmart, the investment in Inventory and Receivables after factoring the time taken for paying Accounts payable is returned back to the company in only 2 Days

Such a very low cycle is possible only when the company manages its Receivable, Inventory and Accounts Payable in the most efficient manner.

As seen in the calculations above, although, the Inventory Days for Walmart is high, it is offset by similar Payable Days.

Hence the company is able to achieve such a low Cash Conversion Cycle.

## Cash conversion cycle interpretation

### High Cash Conversion Cycle

• This indicates that the company is inefficient in managing its cash.
• The conversion cycle can be longer if the Receivable Days and Inventory Days are relatively higher than the Payable Days.
• Such a high conversion cycle will lead to lower liquidity since it is taking longer period to receive the cash.

### Low Cash Conversion Cycle

• A low conversion cycle indicates that the company is very efficient in managing its cash.
• The conversion cycle can be low if the Payable Days are relatively higher than Receivable Days and Inventory Days.
• This signifies the Reputation and Brand Image of the company through which the company is able to defer the payment period of its Accounts Payable.
• A low cash conversion cycle will also lead to a higher liquidity position since cash is received back in a very short period.

## Trend Analysis

The trend analysis of any financial ratio is an integral part of financial analysis.

It helps in identifying any unusual movement in the ratios. It indicates if the performance of a ratio is sustainable or it is a one-time event.

Let us look at how the ratio has moved in the case of Walmart for the past 5 years.

Source

The conversion cycle for Walmart back in 2015 was as high as 12 days.

But subsequently, the company was able to manage its Inventory and Accounts Payable in the most efficient manner.

As evident in the chart above, Inventory Days back in 2015 was 45 days and Payable Days was 39 days.

Gradually, the company was able to manage these two ratios more efficiently.

As a result of this, during 2019, the Payable Days surpassed the Inventory days in 2019.

Payable days of 44 days > Inventory days of 42 days.

As a result of all this, currently, Walmart Cash Conversion Cycle is only 2 days.

Hence, this Trend Analysis helped us in identifying the great turnaround in achieved by Walmart.

## Comparison with similar companies

Apart from performing Trend Analysis for a given company, it is also important to analyze how different is the ratio when compared to other similar companies.

This helps in understanding cross-sectional industry dynamics.

### Walmart vs Home Depot

In the case of Home Depot, there has been a moderate fall in the ratio which is a good sign.

The ratio, back in 2014 was 42 days. Subsequently, the company was able to manage its Inventories, Receivables, and Accounts Payable more efficiently.

As a result of which cash conversion cycle for Home Depot is currently at 37 days.

Compared to Walmart the cycle for Home Depot is very high. This is because in the case of Home Depot, both the inventory days and payable days are unfavorable.

Nonetheless, Company is able to gradually decrease its cycle which is a good indication.

### Walmart

We have already discussed the turnaround achieved by Walmart as part of Trend Analysis.

The company was able to manage its Inventory and Accounts Payable in the most efficient manner such that its current conversion cycle is only 2 days.

### ExxonMobil

When we calculate the cycle for ExxonMobil, a US-based multinational oil and gas company, we can see that the ratio has increased significantly.

Although there was an increase in Payable Days for the company, such an increase was offset by a corresponding increase in Inventory Days and Receivable Days leaving no room for improvement in the overall cash conversion cycle.

Currently, ExxonMobil Cash Conversion Cycle is 20 days.

## Can the cash conversion cycle be negative?

To understand why the ratio can be negative, let us look at the formula once again.

We add Inventory Days and Receivable Days and reduce Payable Days.

Hence, if the Payable Days > (Receivable Days + Inventory Days), naturally the cash conversion cycle can be negative.

## Negative cash conversion cycle interpretation.

A negative cash conversion cycle basically indicates that the company is able to grow its sales by utilizing the cash which was supposed to be paid to the supplier.

Hence, the company is managing its liquidity position in the most efficient manner and aiding the company’s growth on suppliers’ money.

Let us look at a real-life example to understand how the cash conversion cycle can be negative.

### Apple

As evident from the chart above, the Cash Conversion Cycle for Apple is negative.

A company like Apple would undoubtedly have a Reputation and Brand Image in the market.

Hence, the suppliers will be ready to offer higher than normal credit period.

As a result of which the Payable Days will be higher.

If the Payable Days are significantly high and Inventory Days & Receivable Days are relatively low, naturally the Cash Conversion Cycle will be negative.

Hence, even in the case of Apple, the cash conversion cycle is negative.

Because of its Reputation and Brand Image, it was able to avail higher credit period which lead to higher liquidity.

Hence, the company was able to grow its sales by managing its Payable Days.

Currently, Apple’s cash conversion cycle is negative 74 days.

Hence, the example of Apple clearly shows that yes, Cash Conversion Cycle can be negative.

### Amazon

Amazon is into e-commerce, cloud computing, digital streaming, and artificial intelligence and other similar business.

Similar to Apple, even Amazon has a negative cash conversion cycle.

The Payable Days, in the case of Amazon, is way higher than Receivable Days and Inventory Days together.

The ratio, back in 2014 was -24 days and currently, Amazon cash conversion cycle is negative 28 days.

As already highlighted, this indicates that the company was able to grow the sales by managing its liquidity position in the most efficient manner.

The conversion cycle for Facebook has moved from being negative to positive.

The ratio, back in 2014 was -15 days.

But, subsequently, the Payable Days increased significantly relative to Receivable days.

This led to an increase in the ratio.

Currently, the Facebook cash conversion cycle is as low as 2 Days.

This indicates better liquidity management.

### Microsoft

When we calculate the ratio for Microsoft, we can observe that the company is not able to decrease the cycle.

For the past 5 years, the ratio has been in the same range of 26-30 days.

Currently, Microsoft Cash Conversion Cycle is 26 days.

Similar to Microsoft, even Google is unable to reduce its conversion cycle. Instead, the ratio is increasing for the past 5 years.

Receivable Days are moderately increasing while Payable Days are decreasing. This is leading to an overall increase in the cash conversion cycle.

This indicates that the company is finding it difficult to manage its overall liquidity position.

Currently, Google cash conversion cycle is 35 days.

### Important considerations

Below are few important aspects one must consider while analyzing any company using the Cash Conversion Cycle.

The Cash Conversion Cycle be negative

As already illustrated, when the Payable Days are higher than Receivable Days & Inventory Days together, cash conversion cycle will naturally be negative.

Scroll through below recommended resources or learn other important liquidity ratios.