Cash conversion cycle :- important parameter especially for retail businesses to manage!

I come across through my research, one overlooked and seldom discussed but very important metric which is "cash conversion cycle". Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables). Cash conversion cycle is especially important for retail businesses that rely heavily on selling their goods fast and receiving payments fast and being able to delay payment to its suppliers to a suitable time in order to pay them. Cash conversion cycle can also be applicable to other businesses that purchase and hold goods (inventory) to sell to customers.

If cash conversion cycle is not efficient, it may mean significant losses for the business in the end. Inventory pilling up with goods that cannot be sold (even more drastic for perishable goods that cannot be sold that can cause a loss on asset value), customers delaying payments and suppliers chasing for payments; all these can put extreme pressure on the business which may even damage the business permanently if cash conversion cycle is not brought back to an efficient level for a prolonged period of time.

Thus, a business (especially of a retail nature) hope to sell its products as fast as possible (resulting in high inventory turnover), collect payments from its customers as fast as possible for goods sold (resulting in high receivables turnover), but pay suppliers as slowly as possible (resulting in low payables turnover). It is most ideal if a business can sell its goods and collect payments from its customers before it has to pay its suppliers. Most businesses should be able to collect direct payments from its customers unless a business extends credit terms to its customers (of which an investor should be wary since there is a risk that the business may not receive payments from its customers compared to upfront immediate payments for goods sold which has no risk of default on payments since customer payments is immediate upon receipt of goods).

Cash conversion cycle calculation

Cash conversion cycle = Days in Inventory + Days in Receivables - Days Payable Outstanding

This is the basic formula for cash conversion cycle of a business.

Days in inventory, days in receivables and days payable outstanding can be calculated as follows.

Days in Inventory = 365 / Inventory turnover  

           Inventory turnover =
           Cost of sales or Cost of goods sold / Inventory

Days in Receivables = 365 / Receivables turnover

          Receivables turnover = Revenue / Accounts receivable

Days Payable Outstanding = 365 / Payables turnover

         Payables turnover =
         Cost of sales or Cost of goods sold / Accounts payable

As one can see, we need the raw data for Inventory, Cost of sales, Revenue, Accounts receivable and Accounts payable. Figures for Inventory, Accounts receivable and Accounts payable can be found in the Balance Sheet Statement. One should consider using Accounts receivable and Accounts payable both under current assets and current liabilities respectively only since accounts that are current involve assets and liabilities over a one year period (since cash conversion cycle is calculated for a one year period as well). As for revenue and cost of sales, both can be found under the income statement.

One can consider comparing the cash conversion cycle for same company for different years to assess the trend whether a company has decreasing number of days for its cash conversion cycle over the years which is a positive sign or increasing number of days for its cash conversion cycle over the years which may be a negative sign.

Red flags to look at include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these happening for prolonged period of time. Such red flags are especially bad for retail businesses that rely heavily on their ability to optimise their cash conversion cycle.

An example on calculation of cash conversion cycle for one of my invested company (Tat Hong Holdings)

All financial figures are taken from the year 2009 annual report.

Inventory turnover = 390622000 / 217686000 = 1.7944

Days in Inventory = 365 / 1.7944 = 203 days

Receivables turnover = 631761000 / 97725000 = 6.4647

Days in Receivables = 365 / 6.4647 = 56 days

Payables turnover = 390622000 / 182325000 = 2.1424

Days in Payable Outstanding = 365 / 2.1424 = 170 days

Cash Conversion Cycle = 203 + 56 - 170 = 89 days

Thus, Tat Hong Holdings has a cash conversion cycle of 89 days. One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors. Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.


Discussion points:- Cash conversion cycle measures how fast a company sells its goods (inventory), how fast it collects payments from goods sold (receivables), and how long it can hold on to the goods before it has to pay its suppliers of goods (payables).

Cash conversion cycle is especially important for retail businesses that need to optimise their cash conversion cycle. However, it can also be applied to assess any businesses that rely on purchasing goods and holding goods to sell.

Red flags to look at include increasing days in inventory, low inventory turnover, high number of days in receivables and low number of days in payable outstanding, all these escalating for prolonged period of time which may damage the business resulting in significant losses.

One should compare the cash conversion cycle for similar competitive businesses in same industries and sectors to have a fair comparison on which business has a better cash conversion cycle than its competition, since cash conversion cycle may differ widely if comparing businesses in very different industries and sectors.

Generally, lower number of days for the cash conversion cycle is preferred over a higher number of days.