Online Custom «The Cash Conversion Cycle» Essay Sample
Today, the improvement of profitability of the business is one of the major tasks of the financial manager. The cash conversion cycle plays an important role in the management of primary activity, profitability, and liquidity of the company. In this regard, the essence and main characteristics of the cash conversion cycle have to be studied in more detail in order to define its value in ensuring the long-term success of the company.
The cash conversion cycle defines the number of days of conversion on the basis of the stocks conversion period, the period of encashment of the due sums (receivables), and the payables deferral period. The cash conversion cycle counterbalances the period between the valid monetary costs of the company for the acquisition of resources (raw materials and labor) and incomes from the sale of finished goods, i.e. the period between the payment for labor and materials and encashment of the due sums. Thus, the cash conversion cycle can be equated to the average time during which it is closely connected with the current assets. The ratios of accounts payable and accounts receivable point out the efficiency of use of liabilities and short-term assets by management in order to generate cash. These ratios help the investors to estimate general health of the company (Brigham & Houston, 2009).
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The cash conversion cycle is very crucial for retail businesses. On the contrary, software and insurance companies and consulting businesses are the examples of those for which the metric of the cash conversion cycle is meaningless. This measure reflects the ability of the company to convert its products and goods into cash by means of sales as soon as possible. The firm will benefit from the produced goods in case the cash conversion cycle is shortened. This dependence is explained by the fact that the shorter the cash cycle, the less time and money are involved into the business process. However, this number should be combined with other measures, for example, return on assets and return on equity. In addition, the cash conversion cycle is an especially important measure for comparing the closely competing companies since the company with the lowest indicator of the cash conversion cycle usually has the most successful management (Brigham & Houston, 2009).
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The aim of the financial manager is to reduce the cash conversion cycle whenever possible without harming operations. Shortening of the cash conversion cycle will significantly improve the profitability of the enterprise since the longer the term of the cash conversion cycle, the greater the need for external financing, which has its value. The conversion cycle can be shortened in the following ways: by means of reducing the conversion time of inventories and raw materials due to their faster processing and sales; by means of shortening the period of encashment of due means due to encashment speedup; and by means of increase in the period of delay on accounts payable. These measures have to be taken since they give the chance not to increase expenses and reduce sales (Stoltz, 2007).
For the company's cash conversion cycle calculations, the financial manager has to gather the following data from the financial statements: the number of days in a given period, cost and revenue of products sold, inventory, accounts payable, and accounts receivable at the beginning and end of the considered period of time. The time period can make one year, i.e. 365 days, or a quarter, i.e. 90 days. Inventory, accounts payable, and accounts receivable are the figures of two different balance sheets; therefore, the experts should use different balance sheets for each time period (Fazal, 2013).
The results of the cash conversion cycle calculation can be zero, positive and negative. Pros of positive cash cycle include convenient terms of payment, i.e. the customers receive more time to pay, thus increasing market share. Besides, the number of creditors will increase, providing easy access to suppliers because of short payable periods. Cons of positive cash cycle are the following: higher risk of bad debts, increased requirements for working capital, responsibility of businesses to pay their creditors even if customers have not yet transferred money, and, finally, risk of unexecuted orders. In its turn, negative cash cycle has its own pros and cons, which are rather different from those of positive cash cycle. The pros of negative cash cycle are as follows: creditors may provide indirect sources of financing. As a result, short-term loans will be reduced, and the cost of capital will be cut. Besides, the company receives an opportunity not to pay its creditors until the consumers pay. Owing to availability of free cash, companies get new prospects of investments. Cons of negative cash cycle include loss of income, unsatisfied creditors, and loss of market share (Fazal, 2013).
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The number of the cash conversion cycle in and of itself does not mean much. However, this number should be used in order to trace the performance of the company over time and compare it to its closest competitors. Tracing the company’s performance over time helps to define worsening or improvement of its value. The changes of the cash conversion cycle should be tracked over some years in order to obtain the best understanding of how the performance is changing (Stoltz, 2007).
Taking into account all abovementioned information, it should be noted that the cash conversion cycle is a useful tool for evaluation of the company’s management, particularly if it is calculated for several competitors and consecutive time periods. The company will benefit from its activity if the cash conversion cycle is as low as possible or steady. The cash conversion cycle is most efficient for retailers having inventories, which are sold to their customers. Thus, the cash conversion cycle is a very important metrics reflecting efficient management of the company and a means of assessment of its general performance.