Financial ratios, such as the liquidity ratios, activity ratios, and leverage ratios, and other metrics, including the cash conversion cycle (also known as the net trade cycle) should be used when analyzing a company. These ratios can be used by creditors as well as investors to determine if the company has a clean bill of health. One important aspect of a company to analyze is how well that company is able to meet demands for cash as they arise. The current ratio, quick ratio or acid test, as well as the cash ratio can and should all be used in this process, but the cash conversion cycle should also be calculated.
The cash conversion cycle, which is also known as the net trade cycle, measures in days the normal operating cycle of a firm. This figure takes into consideration the process of buying raw materials, manufacturing inventory, the creation of accounts receivable and accounts payable, as well as collecting cash. It is important to look at this, especially when it is compared to the company’s previous years as well as industry averages, as it gives insight to whether the company’s cash flow generation abilities has improved or deteriorated over a period of years.
Cash Conversion Cycle = Average Collection Period + Days in Inventory – Days in Payables
In order to calculate the cash conversion cycle three ratios must first be calculated by using key balance sheet accounts: the average collection period, the number of days inventory is held, and the number of days payable are outstanding. In the following examples 365 days is used to determine the average daily figures, which may not always be the case. Additionally, in some cases, average net accounts receivable, average inventory, and average accounts payable figures are used.
Average Collection Period = Net Accounts Receivable / (Net Sales / 365)
The average collection period represents the average number of days it takes a company to convert their net accounts receivables into cash, and calculated by dividing net accounts receivable by the average amount of daily sales. It is important to remember that net accounts receivable is used which is different than accounts receivable as net accounts receivable considers any amount of accounts receivable that management thinks may never be collected. On the balance sheet of a company net accounts receivables is either listed as its own balance sheet account, or accounts receivable is listed with a second line item for any doubtful accounts. Also, if available, net credit sales should be substituted for net sales as the credit sales produce the receivables.
The average collection period can tell a lot about a firm’s credit policy. If the average collection period is high compared to an industry average, this may mean that the company has sold goods on account to less creditworthy customers to boost sales. However, if the average collection period is less than the industry average then this may mean that the company’s credit policies are too strict and that they could be loosing business. For instance, the average collection period for Tesla, Inc. in 2018 and 2017 was 16.14 days and 16.00 days, respectively. Although this slight increase may not seem very significant it is important to realize that net sales for some companies analyzed could be in the billions, and even a slight increase in the average collection period could mean the company collected millions of dollars less than in previous years to use in day to day operations.
Days In Inventory = Inventory / (Cost of Goods Sold / 365)
The second figure involved in determining the cash conversion cycle is the number of days inventory is held, or the days in inventory, which is just the average number of days it takes for a company to sell its inventory. Days in inventory is calculated by dividing inventory by the average daily cost of goods sold (COGS) which is equal to COGS/365. A low days in inventory for a company could be a good thing, as it means that management manages inventory efficiently, however if it is too low then this may mean that the company does not have enough inventory to meet customer’s demand. If the number of days inventory is held is too high, this could mean that the inventory held is obsolete and will need to be sold at cost. However, a high number of days in inventory could also mean that the company is stockpiling inventory for strategic purposes – the company may be planning to open a new retail store and are anticipating higher demand for their products.
It is especially important to know what type of industry the company is operating in when analyzing the amount of days inventory is held, as well as understanding what inventory valuation method the company is using. For instance, a retailer, especially one of perishable items, should have a much lower days in inventory then a manufacturer of airplanes. In 2017, Tesla, Inc. had an average days in inventory of 86.6, and in 2018 the same company’s days in inventory was just 65.2.
Days in Payables = Accounts Payable / (Cost of Goods Sold / 365)
Calculating the average number of days it takes for the company to pay its payables with cash is the last step in order to determine the net trade cycle. The days in payables is found by dividing accounts payable by the average daily cost of goods sold.
Just like the days in receivables shows how efficiently a company manages its accounts receivables, the days in payables shows how efficiently a company pays their outstanding accounts. This metric offers insight into how quickly a firm pays its suppliers. Compared to the industry the company is operating in, a low number of days in payables means that, although the company is meeting the terms of their suppliers, they could be using that cash elsewhere. A high number of days in payables can be advantageous as the company is holding onto cash longer and could be putting it to good use, and even may be receiving a return if the cash is invested in a short term investment such as a money market instrument.
In 2018, Tesla Inc.’s average number of days in payables was 71.3, compared to roughly 91.5 days in 2017.
Finally, calculating the cash conversion cycle.
Now that the average collection period, days in inventory, and days in payables have been calculated, the cash conversion cycle can be determined by adding together the average collection period and the number of days in inventory (these two figures added together is also known as the operating cycle), and then subtracting the average number of days in payables.
In 2018, Tesla, Inc. had a cash conversion cycle of just 10 days, compared to 11.15 days in 2017.
Seeing the cash conversion cycle increase/decrease alone may not mean a whole lot, but once the three components, as well as the factors that influence these three components are understood, the cash conversion cycle is a much more useful metric to analyzing the cash generating power of a company.