Understanding Cash Conversion Cycle in Business
Cash conversion cycle is a financial metric that measures the length of time it takes for the operations of a company to generate cash in the business. Alternatively, it is the time for which a business needs to look out for sources of financing other than operations, such as existing cash or working capital loans.
Calculation of Cash Conversion Cycle
It is calculated as follows:
The average time it takes a company to convert input goods into sales (Inventory days)
The average time it takes the company to collect payment from its customers (Receivable days)
The average time it takes the company to pay its suppliers (Payable days)
Negative Cash Conversion Cycle
If the resulting number is negative, it means that the company is receiving cash from customers more quickly than it is paying out cash to suppliers, which is a desirable situation for any business. This can occur for several reasons, such as having quick inventory turnover, short payment terms from customers, or extended payment terms from suppliers.
A negative cash conversion cycle may suggest that a business is a cash haven, with suppliers funding operations, making it an attractive investment opportunity.
The Other Side of the Story
However, delaying payment to suppliers can result in damaged credit, and strict collection policies may discourage repeat customers.
Hence, it's essential to find a negative cash conversion cycle that's sustainable or occurs naturally, like in the case of a retail business such as Domino's 🍕:
- Customers usually pay upfront for their orders
- Raw materials are perishable and cannot wait too long for processing into the final product (one of the reasons to follow the Just-in-Time approach)
- Moreover, thanks to their regular business and good reputation, vendors often extend longer credit terms to the company