Cash Conversion Cycle Case Studies
I’ve talked a lot about net working capital in several of my posts. In fact, I used it in my post this Monday when trying to determine Apple’s distributable cash. For those that felt lost, I had once described this process in my post on how to analyze businesses in a recession. Upon looking over these posts, I’ve realized that some who are unfamiliar with working capital metrics and how they work may remain confused so I’m going to try to make it even clearer.
For this case study, it will help to know how to calculate various working capital turnover metrics – Receivable Days, Inventory Days, and Payable Days. You can find that in my Fundamental Analysis Series. But, I’ll review it quickly as we go.
Here, we have two businesses. Jimmy’s Computer Builders is a computer business for which customers order a computer, pay money immediately, and then Jimmy builds the computers and sends them to the customer ten days later. Joey’s No-Money Down Computers is trying to win over customers by offering to allow customers to pay for their computers 60 days after they order them. Otherwise, Joey operates exactly the same as Jimmy’s by building computers within ten days. Both companies use the same suppliers and have received 30-day terms. That is, their suppliers expect to be paid within 30 days of delivering parts to the businesses.
Despite operating basically the same business, Jimmy has negative net working capital of $3,288 where as Joey has positive net working capital of $4,932. What does this mean? It means that Jimmy’s business “creates” $3,288 of cash simply by operating. He collects money up front, buys parts, builds the computers, sends them to the customer and then leisurely pays back his suppliers. Joey’s business, on the other hand, requires $4,932 to operate. He needs to find a way to get cash, buy parts, build the computers, then pay his suppliers all before getting any money from his customers.
What we’ve just described is each business’ cash conversion cycle (CCC). The CCC determines how much financing a Company needs to operate and grow or how well a Company may be able to finance its own growth and operations. Let’s look at these two businesses one at a time.
Jimmy’s Computer Builders (Upfront Payments)
In the case of Jimmy’s business, as the Company receives more and more customers, each customer pays up front and allows Jimmy to use their money to finance his business’ growth as he can take their payments and invest in new inventory to build and sell. Jimmy has a negative working capital business. For Jimmy, however, if business tapers off or he’s forced to liquidate, he will lose the benefit of new cash but still have suppliers to pay. As such, in a downturn, Jimmy cannot be complacent with his cash management. In a larger sense, he can’t be taking all his extra cash and dividending to his shareholders or investing in new projects unless his business is stable or consistently growing.
Joey’s No-Money Down Computers (Delayed Payments)
Joey, on the other hand, requires financing to get his business started. He needs to find money (probably through issued debt) in order to get inventories and pay suppliers while he waits for his customers to pay 60 days later. Joey has a positive working capital (think: he requires capital to do work) business. As Joey’s business grows, he will need more and more outside financing to invest to service his increasing customers. This could be difficult and limiting. On the other hand, if Joey’s business cycles down, he should theoretically be able to collect his receivables and pay his suppliers as well as the debt he incurred to run the business. There is however, more payment risk as some customers may just not pay and Joey will be left holding the bag for having spent time and money building a computer.
Cash Conversion Cycle Days
Just how much of his business can Jimmy self finance? Or, how much cash does Joey need to finance his business? This is calculated by a simple equation:
Cash Conversion Days = Inventory Days + Receivable Days – Payable Days
Basically, the time it takes to turn your inventory into sales plus the amount of time it takes to receive cash from each sale minus the days you have to pay your suppliers shows how many days worth of cash you business either makes available or consumes. Inventory days is calculated by dividing average annual inventory by cost of goods sold (inventory turns) and multiplying by 365. Receivable days is calcuated by dividing average annual receivables by sales (receivable turns) and multiplying by 365. And, finally, payable days is calculated by dividing average annual payables by cost of goods sold (payable turns) and multiplying by 365.
As to be expected by the negative working capital, Jimmy’s Computer Builders creates 20 days worth of cash. This implies that Jimmy has 20 days to freely use a customer’s payments before either getting more cash from other customers (if the business is growing) or using this cash to pay off his current liabilities (in our example his suppliers). On the other hand, as implied by Joey’s positive working capital, Joey ’s business has a 10 day CCC which implies that he needs outside financing of 10 days worth of operating cash in order to keep his business operating smoothly.
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