Investors have a tendency to focus on the earnings potential of a business when reviewing selections for their portfolio. This is for good reason -- profitability is an important predictor of their equity growth. However, it's important also to take a good look at a business's cash situation, as companies with strong earnings can find themselves in trouble if they don't have enough cash coming in to satisfy their debts. The length of the cash cycle is one major indicator of potential cash problems.
Cash Cycle Basics
The cash cycle ratio is a measurement of how efficiently a business manages its cash flows and inventory. The length of the cash cycle is the amount of time the business requires from its initial purchase of inventory goods to receive cash from customers as payment for sales of those goods. It is computed by adding the company's days' sales outstanding in receivables to its days' sales in inventory and subtracting days' purchases in accounts payable. This figure helps evaluate the business's likelihood of having sufficient liquid assets -- cash -- available to meet its debt obligations.
Days' Sales Outstanding
The days' sales outstanding ratio represents the number of average daily sales are tied up in accounts receivables. It's essentially a measurement of the amount of time it takes to collect cash from a credit sale. A business can compute days' sales outstanding by dividing its ending accounts receivable balance by its total revenue for the year. This number is then divided by 365 to convert the figure from number of years into number of days. Days' sales outstanding is also known as receivable days.
Days' Sales in Inventory
Knowing the amount of time cash is tied up in receivables is not enough to determine the entire cash cycle. This is because the business's capital spends considerable time locked down in inventory before it's even converted to a credit sale. The company determines the amount of time it holds inventory by dividing its ending inventory by cost of goods sold, the total of inventory purchases for the year. This number is again divided by 365 to convert the number into days.
Days' Purchases in Payables
Finally, the business must subtract from the cash cycle the time it spends between ordering inventory and actually outlaying cash. Depending on its agreements with vendors, the company may have a considerable number of days in inventory before it actually pays cash for its orders. This number is represented by days purchases' in payables, which consists of the ending balance of accounts payable divided by cost of goods sold, converted to days. This ratio is subtracted from the sum of receivable and inventory days to arrive at the total length of the cash cycle.
- "Encyclopedia of Small Business"; Cash Conversion Cycle; Kevin Hillstrom and Laurie Hillstrom; 2002
- Halcolm Bard Certified Public Accountant and Consultants; Analysis of Cash Cycle; 2010
- Professional Education, Testing and Certification Organization International; Cash Cycle; John Petroff; 2000
- Bluepoint Strategies; Cash Conversion Cycle; Christopher Gattis; September 2009
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