Sometimes referred to as an asset conversion cycle or a net operating cycle, the cash conversion cycle is a simple process that is used to evaluation the current financial stability of a business. Essentially, the cash cycle looks at the time periods associated with several basic elements of doing business. Understanding cash conversion cycles can give a business some concept of how long certain assets are tied up in the production, payables and receivables process and are thus not available for use in making investments in the business operation.
It is helpful to think of the cash conversion cycle as identifying the number of days it takes from the acquisition of the raw materials used to create products all the way through to the time that payment is received for the manufactured goods. This is compared to what is known as the average stockholding period. Essentially, this is the closing stock at the end of the day, and what the return would be if the raw materials were paid in full and payment had been received for the goods that were produced using those same raw materials.
Obviously, a shorter span of days is the indication of a positive cash conversion cycle, since the investment is returned with a profit in a shorter period of time. Because the return is received sooner rather than later, there is the opportunity to invest the collected net revenue and accrue an even greater return. More return from the investment means more revenue that can be used to expand production or benefit the business in some other manner.
Longer or negative cash cycles can indicate there is a problem somewhere in the process. The problem with the cash conversion cycle may be in the area of Accounts Receivable, if some customers are taking longer to pay outstanding invoices for the delivered goods. In the event that the business is delaying payment on the raw materials until the finished goods are paid for by the customer, there may also be additional finance charges that run up the overall raw materials costs. If a long cash conversion cycle is indicated, it is important to analyze the situation thoroughly, uncover what is causing the delays, and take steps to correct the situation.
