What Are the Benefits of a Positive Cash Conversion Cycle?
A company's cash conversion cycle is the amount of time it takes to convert inventory purchases into cash flows. It measures how quickly and efficiently a company extracts cash from operations. To calculate the cash cycle, add days of outstanding sales to days inventory outstanding, and then subtract days payable outstanding. A low number means that the company has a positive cash cycle and is efficiently managing operations.
In a positive cash conversion cycle, the company does an excellent job of collecting on accounts receivable. Perhaps the company offers incentives for customers to pay quickly or focuses on friendly and efficient collections. A huge benefit of quick collection is a lower amount of uncollectible debt. Generally, the older the past due balance is, the less likely it is that the company will ever be able to collect on the account. A positive cash conversion cycle means that the company can leave a smaller allowance for uncollectible accounts and boast higher assets.
Inventory moves off the shelves quickly in companies with positive cash conversion cycles. Like accounts receivable, older inventory is higher risk for the company. If the company sells perishable goods, they may have to completely discard older inventory and take a hit to their bottom line. However, non-perishable products are at risk, too. Customer tastes can change quickly, and old inventory may have to be written down and sold at a discount. A positive cash conversion cycle means that the company gets top dollar for their inventory and is able to quickly adjust to any changes in customer product preferences.
Companies with positive cash conversion cycles carefully time their vendor payments. These companies generally have longer payment terms with greater flexibility. Late vendor payments can cause strain on the relationship and generate costly late fees for the company. Companies with short cash conversion won't have problems making these payments and can take advantage of early payment discounts when they want to.
Just because a company has a short cash conversion cycle doesn't mean that they have unlimited funds. Just like any other company, the company may run into unexpected expenses or find themselves with a short amount of time to invest in a new product or growth opportunity. Many small businesses quickly fail due to seasonal business and cash shortages. For this reason, lenders heavily consider a company's cash flow when making decisions regarding amounts and rates. Showing a positive cash conversion cycle reassures lenders that you can collect on all of the profits you generate.