The cash conversion cycle measures the number of days it takes for working capital to be converted to cash, and it is calculated by deducting payable days from the total of receivable days and inventory days.
The formulae for calculating payable days, receivable days and inventory days are as follows:
Accounts Receivable Days = (Accounts Receivable/Total Sales) x 365
Inventory Holding Days = (Inventories/Total Cost of Goods Sold) x 365
Accounts Payable Days = (Accounts Payable/Total Cost of Goods Sold) x 365
Since the cash conversion cycle is a critical measure of cash conversion, management is motivated to use various tricks to shorten the cash conversion cycle and create a better picture of the company's performance. I will introduce three tricks here, which management can potentially employ.
First, management can reduce receivable days by factoring. Factoring refers to the sale of accounts receivables to a third party at a discount. By factoring its receivables, receivables are removed from the balance sheet and receivable days are reduced. There are two types of factoring: recourse factoring and non-recourse factoring. In the case of recourse factoring, the company is still exposed to credit risk, as the factor can go back to the company for payment if the customer defaults.
Second, inventory days can be shortened by re-classifying some of the unsold inventories as other current assets. In some extreme cases, management can attempt to even re-classify unsold inventories for more than a year as non-current assets.
Last, if management makes advance payments to suppliers, these advance payments are not netted from the accounts payable balance, potentially distorting payable days. Investors should re-calculate payable days by netting off advance payments to suppliers from trade payables.
The formulae for calculating payable days, receivable days and inventory days are as follows:
Accounts Receivable Days = (Accounts Receivable/Total Sales) x 365
Inventory Holding Days = (Inventories/Total Cost of Goods Sold) x 365
Accounts Payable Days = (Accounts Payable/Total Cost of Goods Sold) x 365
Since the cash conversion cycle is a critical measure of cash conversion, management is motivated to use various tricks to shorten the cash conversion cycle and create a better picture of the company's performance. I will introduce three tricks here, which management can potentially employ.
First, management can reduce receivable days by factoring. Factoring refers to the sale of accounts receivables to a third party at a discount. By factoring its receivables, receivables are removed from the balance sheet and receivable days are reduced. There are two types of factoring: recourse factoring and non-recourse factoring. In the case of recourse factoring, the company is still exposed to credit risk, as the factor can go back to the company for payment if the customer defaults.
Second, inventory days can be shortened by re-classifying some of the unsold inventories as other current assets. In some extreme cases, management can attempt to even re-classify unsold inventories for more than a year as non-current assets.
Last, if management makes advance payments to suppliers, these advance payments are not netted from the accounts payable balance, potentially distorting payable days. Investors should re-calculate payable days by netting off advance payments to suppliers from trade payables.
