Cash conversion cycle is part of a firm’s total operating cycle and measures the length of time between paying suppliers for inventory purchases and receiving cash from customers after sales. The total operating cycle typically starts with ordering and receiving inventory supplies, paying suppliers either at the time of the purchase or sometime later, making sales and receiving cash from customers at the time of the sales or by future credit collections. Cash conversion cycle is also the total operating cycle minus the accounts payable period -- the delayed payment time.
Inventory Holding Period
The inventory holding period is the block of time during which cash used for inventory purchases is tied up in the production process that converts raw materials to final products as in manufacturing. In retail, the inventory holding period is the time of the resale process by which merchandises are moved from storage to shelves and lastly to customers. The longer the inventory period, the longer the total operating cycle and potentially the longer the cash conversion cycle.
Accounts Receivable Collection
Accounts receivable collection is another part of the cash conversion cycle. The period of accounts receivable collection is the time between the sales made and accounts receivable collected if sales are made to customers in credit terms. The collection of accounts receivable in cash signifies both the end of the total operating cycle and the completion of cash conversion cycle. The longer the accounts receivable collection period, the longer the total operating cycle, and likely the longer the cash conversion cycle, depending on the accounts payable period.
Accounts Payable Period
Unlike the inventory holding period and the accounts receivable collection period that have a positive relationship with the cash conversion cycle, the accounts payable period has a negative relationship with the cash conversion cycle. Accounts payable period is the time between receiving inventory supplies and actually paying for them. Companies can sometimes get trade credit from suppliers that help them delay the cash outflows in the operating cycle. Given the inventory holding period and the accounts receivable collection period, the longer the accounts payable period, the shorter the cash conversion cycle.
Cash Conversion Cycle
A typical cash conversion cycle starts with paying suppliers for inventory purchases and ends with collecting cash on accounts receivable from customers. Based on the starting point of the cash outflows, cash conversion cycle is calculated with the accounts payable period as a subtraction from the total operating cycle. In general, cash conversion cycle equals the inventory holding period plus the accounts receivable collection period, minus the accounts payable period. Therefore, a longer accounts payable period has the effect of shortening the cash conversion cycle.
An investment and research professional, Jay Way started writing financial articles for Web content providers in 2007. He has written for goldprice.org, shareguides.co.uk and upskilled.com.au. Way holds a Master of Business Administration in finance from Central Michigan University and a Master of Accountancy from Golden Gate University in San Francisco.