The cash conversion cycle measures the period of time in days from the moment inventories are paid until the moment accounts receivable is collected. In other words, it is the duration of working capital turnover. Therefore, the duration of the cash conversion cycle determines the working capital needs of a business. The longer it is, the greater the working capital needs and vice versa.
The duration of the cash conversion cycle can be calculated as follows:
Cash Conversion Cycle = Operating Cycle - Days Payables Outstanding
Using a deeper decomposition of the operating cycle, the equation above can be transformed as follows:
Cash Conversion Cycle = Days of Sales in Inventory + Days of Sales Outstanding - Days Payables Outstanding
Formulas for days of sales in inventory (DSI), days of sales outstanding (DSO), and days payables outstanding (DPO) are as follows:
|DSI =||Average Inventory||×T|
|DSO =||Average Accounts Receivable||×T|
|DPO =||Average Accounts Payable||×T|
|Cost of Sales|
where COGS is the cost of goods sold, and T is the number of days in an accounting period.
Cost of Sales = Beginning Inventory + Purchases - Ending Inventory
The graph below shows the relationship between the operating cycle and the cash conversion cycle.
As was mentioned above, the shorter the cash conversion cycle of a business, the lower its need for working capital. It can also happen that its value turns negative. It means that the accounts payable period is greater than the duration of the operating cycle of a business. In such a case, the working capital needs of a business are financed by trade accounts receivable.
Information about inventory, accounts receivable, and accounts payable of Total SAR in the 20X8 financial year is as follows:
The company also reported in 20X8 credit sales of $5,475,000, cost of goods sold of $3,285,000, and purchases of $2,920,000.
Let’s find the days of sales in inventory, days of sales outstanding, and days payables outstanding of Total SAR.
|Average Inventory =||$580,000 + $500,000||= $540,000|
|Average Accounts Receivable =||$730,000 + $770,000||= $750,000|
|Average Accounts Payable =||$310,000+$330,000||= $320,000|
Cost of Sales = $580,000 + $2,920,000 - $500,000 = $3,000,000
|DSI =||$540,000||× 365 = 60 days|
|DSO =||$750,000||× 365 = 50 days|
|DPO =||$320,000||× 365 = 39 days|
Thus, the duration of the cash conversion cycle of Total SAR is 71 days (60+50-39).