3 Things to Know about a Company’s Cash Conversion Cycle

How to identify a company that is efficient in managing its cash flows and thus, having the ability to either pay consistent dividends and invest for growth from the others which could not? 

The answer lies in calculating its cash conversion cycle (CCC). In essence, it tells us whether or not, a company is cash tight, needing funds to operate on a daily basis or if the company has the freedom to use its cash to either invest or make consistent dividend payouts to its investors. 

For a start, CCC is measured based on time with the formula below:

Cash Conversion Cycle (CCC) 

= Inventory Days + Receivable Days – Payable Days 

A company is viewed to have better cash flow management if its CCC is lower. It indicates the company is good in bringing in cash flows from customers. Thus, it is often preferred by investors. Here, I’ll explain the formula in great detail and I would share its application so that you can make use of it easily. 

#1: Inventory Days 

It measures how quickly a company sells its products to customers. If inventory days of a company is low, it often indicates that it is good in selling its products. Therefore, a company with high inventory days are not preferable. The formula of inventory days is stated below: 

Inventory Days 

= (Average Inventory / Cost of Sales) x 365 days 

Average Inventory 

= (Inventory at Beginning of Year + Inventory at the End of Year) / 2

Let’s use Panasonic Manufacturing Malaysia Bhd (Panamy) as our case study. In 2019, it has the following:

Inventory at Beginning (31 March 2018) = RM 50.331 million 

Inventory at the End of the Year (31 March 2019) = RM 49.580 million

Cost of Sales (Financial Year 2019) = RM 919.762 million 

As such, its inventory days is calculated as follows: 

Average Inventory 

= (Inventory at Beginning of Year + Inventory at the End of Year) / 2

= (RM 50.331 million + RM 49.580 million) / 2 

= RM 49.955.5 million

Inventory Days 

= (Average Inventory / Cost of Sales) x 365 days 

= (RM 49.9555 million / RM 919.762 million) x 365 days

= 19.7 days 

It means, Panamy took 19.7 days to convert its raw materials into products and had them sold to its customers in financial year (FY) 2019. 

#2: Receivable Days 

A company would recognise revenues, once it has transferred the ownership of its products and services to its customers. The customer could either settle the payment in cash upon delivery (cash sales) or receive the products and settle it later and thus, owing to the company (credit sales). 

Receivable Days measures how quickly a company is able to collect cash after it had billed its customers. A company with lower receivable days indicates that it can a company that is doing cash sales or one that is efficient in getting paid by its customers. This is important because a company often has bills to pay. They include rent, utilities, wages, advertising, distribution, logistics … etc which are often paid on a monthly basis. Hence, a company with lower receivable days is often preferred by investors. The formula is stated below: 

Receivable Days 

= (Average Trade Receivables / Revenues) x 365 days 

Average Trade Receivables

= (Receivables at Beginning of Year + Receivables at the End of Year) / 2

In 2019, Panamy has the following: 

Receivables at Beginning (31 March 2018) = RM 125.630 million 

Receivables at the End of the Year (31 March 2019) = RM 105.240 million

Revenues (Financial Year 2019) = RM 1,127.886 million 

As such, its receivables days is calculated as follows: 

Average Trade Receivables 

= (Receivables at Beginning of Year + Receivables at the End of Year) / 2

= (RM 125.630 million + RM 105.240 million) / 2 

= RM 115.435 million

Receivables Days 

= (Average Trade Receivables / Revenues) x 365 days 

= (RM 115.435 million / RM 1,127.886 million) x 365 days

= 37.4 days 

It means, Panamy took 37.4 days to collect payments from its customers after it had billed them for its product sales in FY 2019. 

#3: Payable Days 

A company may receive its bills from its suppliers & distributors for its materials purchased to be used to manufacture its products for sales. Payable Days is one that measures how fast a company pays its suppliers & distributors after having received its bills from them. 

Is having lower payable days preferable? 

In most cases, it is preferable but if a company has higher payable days, it is not really a bad thing, especially if it has a good business relationship with suppliers & distributors for they may extend credits to the company. 

Its formula is stated below: 

Payable Days 

= (Average Trade Payables / Cost of Sales) x 365 days 

Average Trade Payables

= (Payables at Beginning of Year + Payables at the End of Year) / 2

As such, its payable days is calculated as follows: 

Payables at Beginning (31 March 2018) = RM 181.919 million 

Payables at the End of the Year (31 March 2019) = RM 162.973 million

Cost of Sales (Financial Year 2019) = RM 919.762 million 

As such, its payable days is calculated as follows: 

Average Trade Payables

= (Payables at Beginning of Year + Payables at the End of Year) / 2

= (RM 181.919 million + RM 162.973 million) / 2 

= RM 172.446 million

Payables Days 

= (Average Trade Payables / Cost of Sales) x 365 days 

= (RM 172.446 million / RM 919.762 million) x 365 days

= 68.4 days 

It means, Panamy took 68.4 days to settle its bills from suppliers & distributors after being invoiced by them. 

Putting the CCC Formula Together

As such, Panamy’s CCC is calculated as follows: 

Cash Conversion Cycle (CCC) 

= Inventory Days + Receivable Days – Payable Days 

= 19.7 days + 37.4 days – 68.4 days 

= Negative 11.3 days. 

Therefore, typically, here is how Panamy manages its cash flows: 

As such, it is an example of a company where its business is practically financed by its suppliers & distributors. In 2019, Panamy has a total of RM 623.31 million in cash reserves where it has placed RM 480.0 million in fixed deposit where its weighted average interest rate is 3.91% per annum. Therefore, it has received a total of RM 23.854 million in interest income (passive income) in 2019. 

Conclusion:

A company is more preferable to investors if its 

1. Its inventory days is dropping / lower. 

2. Its receivable days is dropping / lower. 

3. Its overall cash conversion cycle is dropping / lower. 

To learn more about how to read a financial statement, check out our series on reading the income statement and balance sheet as well.

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