Chapter 17 Cash and Cash Conversion Cycle

Cash Inflows and Outflows

Any cash coming in to the company is a cash inflowA source of cash or an increase in the company’s cash balance.; for the sake of consistency and to avoid errors, we will always use positive numbers to represent inflows. Any cash leaving the company is a cash outflowA use of cash or a decrease in the company’s cash balance., and will be represented by a negative number. Simply put, inflows are sources of cash while outflows are uses of cash.

When a company pays its advertising bill, it is a cash outflow. When the company receives payment from a customer, it is a cash inflow. Other accounts are a bit trickier. For example, if a firm’s accounts payable increased by $2,000, it is a cash inflow. If inventory increased over the year by $3,000, the change would be negative and an outflow of cash. Let’s start with the summary below.

Cash increases occur anytime you have a decrease in any asset or an increase in liabilities. How is this? If any of your assets decrease (for example accounts receivable or inventory) this means that cash has been freed up to be held as cash instead of being tied up as AR or in inventory. In essence we put money in the safe (a cash inflow) and a have a decrease in our asset. Conversely, a company’s cash balance decreases (cash outflow) if there is an increase in any of its assets. If accounts receivable or inventory increases, then that is more money held as that asset and therefore less money held as cash. So the company’s cash balance decreases.

With liabilities the opposite is true. An increase in any liability such as accounts payable results in an inflow of cash. In other words, if accounts payable increases than that means we did not pay as much on our payables and therefore we are holding more cash. If accounts payable decreases, then we have a cash outflow because we used cash to pay our payables. Profit is a bit easier. So easy in fact we can sum it up in one sentence: Any profit is a cash inflow and any loss is a cash outflow.

Risk and Net Working Capital

There is always a tradeoff between risk and return. Businesses want to minimize risk and maximixe return. Holding cash on the balance sheet provides a safety net, since the more cash available, the lower the chance of not having enough to pay bills as they come due. But cash is a terrible investment: it does not earn a return. Investing cash in projects, other business, securities, etc. can earn a return, but then we risk not having it available when it is needed. Companies try to maximize their return with minimum risk by making sure they hold enough cast to remain solvent, but investing excess cash.

External Funding of Working Capital

Our company’s investment in current assets has to come from somewhere; funding of current assets can be either with short-term or long-term debt, equity, or the sale of long-term assets. Primary sources include bank loans, credit terms from suppliers, accrued liabilities, bonds, and common equity. Each of these sources has advantages and disadvantages. Short-term loans need to be paid sooner, and are typically more sensitive to fluctuations in interest rates. Longer term debt is more predictable, but also typically more expensive.

Seasonal Requirements

Demand for working capital is not constant. We’ve discussed how net working capital can increase due to growth or new projects, but companies can also have seasonal current asset requirements. Ski resorts, ice cream shops, department stores, and many tourist businesses have seasonal funding requirements: they may have different levels of current assets at different times of the year.

Jack Co. and Johnny Co. Seasonal Funding Example

Jack Co. has $25,000 in cash, $100,000 in inventory and $80,000 in Accounts Receivable (A/R). Their Accounts Payable (A/P) is stable at $55,000. What is their permanent funding requirement?

$25,000 + $100,000 + $80,000 = $205,000 − $55,000 = $150,000

Johnny Co. has the same current asset requirements for part of the year. The other part of the year their inventory peaks at $140,000 and their A/R peaks at $135,000. All other variables remain constant. Their permanent funding need is $150,000 (same as Jack Co.), but what is their seasonal funding need?

$25,000 + $140,000 + $135,000 = $300,000 − $55,000 = $245,000

Thus, Johnny Co. needs to have access to $245,000 − $135,000 = $110,000 of extra funding during the peak season.

Aggressive vs. Conservative Strategies

Different people hold their money in different ways. Jane might have $10,000 in her checking account because she frequently travels for work and may need access to a lot of cash. Tim, however, holds only the minimum balance required by his bank in his checking account because he has invested in the stock market. Businesses too have different management strategies. Firms can be aggressive or conservative in their approach to the amount of cash they hold. Firms can follow aggressive (also called tight, restricted or lean) policies where holdings of current assets are minimized. Or they can follow a conservative (relaxed) policy where they hold more current assets. A ‘tight’ current assets policy is riskier, as a company may need to resort to scrambling for cash if unexpected expenses arise. Relaxed assures there is enough cash, but potentially trades off higher profitability due to the extra cash being “unproductive”. Many companies split the difference, using a more moderate or a maturity-matching policy, where fixed assets are financed with long-term debt and equity, and current assets are paid for with short-term financing.

Seasonal funding requirements will also differ by strategy. Conservative companies fund both seasonal and long-term requirements with long-term financing, keeping the extra cash on hand when it isn’t needed. Aggressive companies fund seasonal requirements with short-term financing as needed.

Calculating the Cash Conversion Cycle

The cash conversion cycle is divided into three parts: the average payment period, the average collection period and the average age of inventory. The firm’s operating cycleThe time from the receipt of raw materials until the receipt of cash for the sale of the goods. is length of time from the receipt of raw materials to the collection of payment for the goods sold. This is, essentially, how long it takes from the start of making a new product until we receive cash (on average). The operating cycle is thus the sum of the inventory conversion periodThe average time between when raw materials are received into inventory and product is sold. (the average time between when raw materials are received into inventory and product is sold) and the receivables conversion periodThe average time between a sale and collection of the receipt. (the average time between a sale and collection of the receipt).

The inventory conversion period can be estimated if we know the average balance of our inventory and the average value of goods sold each day of the year. The latter should be equal to cost of goods sold for the year divided by 365.

As an example, if we have $60 thousand in inventory and sell $3 thousand worth of goods every day, then our inventory takes, on average, $60 thousand/$3 thousand per day = 20 days to sell. This, of course, includes production time as well as time that inventory “sits on the shelves”.

Likewise, the receivables conversion period can be estimated if we know the average balance of our account receivables and the average revenues each day of the year. The latter should be equal to revenues for the year divided by 365.

As an example, if we have $12 thousand in receivables and sell $4 thousand in revenues per day, then our receivables take, on average, $120 thousand/$4 thousand per day = 30 days to collect.

In our examples, the operating cycle is 20 days + 30 days = 50 days.

When we purchase raw materials, however, we don’t typically pay for them immediately. Just as we offer customers credit, our suppliers will usually provide opportunities for credit to us. Therefore, our cash is not tied up for the entire operating cycle, but just the time from when we finally have to pay for raw materials. This length of time or payables conversion periodThe average time between acquiring raw materials and payment for them. (the average time between acquiring raw materials and payment for them) is subtracted from the operating cycle to determine the entire cash conversion cycle. Unfortunately, total purchases are not readily available from the income statement, so we will often have to estimate them as a percentage of cost of goods sold.

As an example, if we have $30 thousand in payables and purchase $2 thousand in raw materials per day, then our payables take, on average, $30 thousand/$2 thousand per day = 15 days.

Our examples cash conversion cycle is thus 20 days + 30 days − 15 days = 35 days.

Typically, the shorter the cash conversion cycle, the better, as it means we are keeping our cash moving instead of having it tied up in Net Working Capital. There are other considerations, however. Perhaps, extending collections of receivables, for example, might entice more sales from our customers. Then we need to balance the benefits from the extra sales with the additional costs in Net Working Capital due to the lengthening cash conversion cycle.

How Do We Manage the Cash Conversion Cycle?

When a firm changes any of these variables, then their cash conversion cycle changes. Certain steps can be taken to reduce a firm’s cash conversion cycle. These steps include:

1. Reduce the average age of inventory. Improve their inventory conversion period by making goods and selling them faster through more efficient processes. Avoiding inventory shortages or stockouts helps too.
2. Reduce the average collection period. Speed up collections on accounts receivable. Collect A/R as quickly as possible without losing customers but maintain good credit relations with customers.
3. Increase the payables deferral period. Pay A/P as slowly as possible without harming credit rating or relationship with supplier.
4. Use technology, strategic partnerships and other leverages effectively. Use technology to collect payments, make product or any other use of technology which improves efficiency.

Ethical Considerations

When considering cash management, its tempting to try to decrease our cash conversion cycle at all costs. Some strategies may hurt our relationship with our customers: overly aggressive collections can alienate customers, or we might deny credit to customers when they need our support most.

Unscrupulous managers might also manipulate reporting of current assets to falsely represent the state of the company. They might not properly account for bad debts; net income will consequently be higher, but only as accounts receivable swells into a “ticking time-bomb”. If the manager is rewarded for raising revenue, he or she might relax credit standards and sell to customers who have no capacity to pay. Even if the customer can “scrape together” the payments, perhaps the burden would be too much (for example, a low-income customer leasing a luxury automobile).

Another possibility is overstating the value of inventory. Obsolescence or spoilage can cause the value of inventory to be less than what is represented on the balance sheet.