|
|
|
|
|
| ||||||||||
by: Jeff Schein Calculating cash flow is one of the most important tasks of the business owner. Revenue and expenses are rarely constant in a business and cash requirements need to be planned for shortfalls, seasonal factors or one time large payments. At the end of the day, a company that cannot pay its bills is bankrupt. Unfortunately, while many business owners concentrate solely on their revenues and expenses to manage their cash flow, its usually poor management of the cash conversion cycle that so often leads to a cash crunch in the business. What is the cash conversion cycle and why should I be concerned with it? The cash conversion cycle is simply the duration of time it takes a firm to convert its activities requiring cash back into cash returns. The cycle is composed of the three main working capital components: Accounts Receivable outstanding in days (ARO), Accounts Payable outstanding in days (APO) and Inventory in days (IOD). The Cash Conversion Cycle (CCC) is equal to the time is takes to sell inventory and collect receivables less the time it takes to pay your payables, or: CCC = IOD + ARO APO Why is this cycle important? Because it represents the number of days a firm's cash remains tied up within the operations of the business. It is also a powerful tool for assessing how well a company is managing its working capital. The lower the cash conversion cycle, the more healthy a company generally is. If you compare the results of the cycle over time and see a rising trend it is often a warning sign that the business may be facing a cash flow crunch. Understanding the components of the cycle When evaluating cash flow, those factors directly affecting profit, revenue and expenses, are easy to understand and their affect on cash is straight forward; decreases in costs or increases in profit margin results in less cash going out or more cash coming in, and increased profits. However, the working capital components of the CCC are a little more complex. In simple terms, an increase in the amount of time accounts receivables are outstanding uses up cash, a decrease provides cash; an increase in the amount of inventory uses cash, a decrease provides cash; an increase in the amount of time it takes you to pay your payables provides cash, a decrease uses cash. For example, a decision to buy more inventory will use up cash, or a decision to allow people to pay for goods or services over 60 days instead of 30 days will mean you have to wait longer for payment, and will have less cash on hand. Below is a numerical example of the cycle: Accounts Receivable outstanding in days +90 Inventory in days +60 Accounts Payable outstanding in days -72 Cash Conversion Cycle +78 In the scenario, you have cash tied up for 78 days. It should be noted that you can have a negative conversion cycle. If this occurs it means that you are selling your inventory and collecting your receivables before you have to pay your payables. An ideal situation if you able to accomplish this. Before you say it is impossible, remember that companies such as Wal-Mart are today selling a large part of their inventory before they have to pay for it. While it is not easy it can be accomplished. An Example Let's assume you buy on trade credit from your supplier and an account payable is created. Your supplier wants full payment in 30 days, however, you are selling inventory very fast, sell the inventory a week later and are asking for full payment from your buyer in 7 days. You are now managing your conversion cycle. Consider, on day 1 you generate an accounts payable for 30 days from now. On day 7 you sell the inventory and generate an accounts receivable, which your buyer will pay for in 7 days. What is your conversion cycle in the case? -14 days, pretty good and you congratulate yourself. On day 15, after you receive payment, you are flush with cash and have a choice of reinvesting the money or paying your supplier. What action you take will probably depend on a lot of factors, but as your supplier has provided you interest free cash for another 2 weeks, you may want to use it for those two weeks to generate greater returns; maybe you have outstanding credit you can pay down, you can buy additional inventory, or you may just want to generate interest returns. Now consider that you also provide your buyers 30 days to pay you. On day 1 you generate an accounts payable for 30 days from now. On day 7 you sell the inventory and generate an accounts receivable, which your buyer will pay for in 30 days. What is your conversion cycle in the case? 7 days, not as good. You now have 7 days in your cycle during which you have repaid your supplier but will not receive payment for another 7 days from your buyer. You either need extra cash on hand or a credit line to support you for those 7 days. What does this mean in terms of cash flow and your bottom line? If you have $1 million in annual sales and your receivables are outstanding an average of 60 days, that means you have $164,383 in outstanding receivables. Everyday extra day the receivables are outstanding (e.g. 61 days vs. 60 days) represents an extra $2,740 that is not available to use elsewhere. If you need a credit line to support your receivables and you pay interest at 8% that represents $13,000 in annual interest charges (expenses) based on an average loan balance of $164,000. So, as you can see, the management of the conversion cycle can have a large impact on the business's cash flow and profitability. The management of your cash conversion cycle could determine whether you require a lending facility or not, or whether you can meet financial obligations.
Article Source: http://www.bharatbhasha.net Article Url: http://www.bharatbhasha.net/finance-and-business.php/1897 LD
| ||||||||||
|
| ||||||||||
| Business And Finance >> Top 50 Articles on Business And Finance | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Category - > | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
