GuruFocus Premium Membership

Serving Intelligent Investors Since 2004

Try It 100% FREE for 7 Days!

Free 7-day Trial
All Articles and Columns »

Three Tricks Used by Management to Improve the Cash Conversion Cycle

November 19, 2012 | About:
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.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap deep-value cigar-butts and wide-moat compounders. He publishes value investing case studies, investment checklists, and potential stock ideas on the Cheapskate Investing blog. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website

Rating: 2.7/5 (6 votes)


Please leave your comment:

Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial