Value Recap – A Quick Way to Analyze a Company’s Net Operating Cycle

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Factoring-Solution

 

The Cash Conversion Cycle (CCC) is an effective way to determine how efficient a company can generate cash starting from the point of purchases to its inventories’ point of sales.

 

It is useful to analyze companies which has frequent movement of inventories such as the retailing and manufacturing sectors.

A supermarket selling groceries would have to purchase its supplies with cash up front. Payment which does not occur immediately is recorded as an accounts payable owed to suppliers  in the supermarket’s accounting book. Later on, when inventories are sold via credit card payment, they are recorded as an accounts receivables.  As customers pay off their due credit, the accounts receivables decrease and cash appears in the company’s books. The cash received is used to pay back the suppliers the supermarket had initially owed to. The Cash Conversion Cycle would be able to track these capital movements using a formula shown below:

 

Cash Conversion Cycle (CCC) = Days of Sales Outstanding (DSO) + Days of Inventory Outstanding (DIO) – Days of Payables Outstanding (DPO)

An example to calculate the CCC can be referenced to Walmart (NYSE: WMT), an American retail corporation that runs a chain of large discount departmental stores.

 

Days of Sales Outstanding

The Days of Sales Outstanding (DSO) is the number of days it would take for a company to receive cash payments. The lower the DSO, the more efficient the company is able to receive cash from its customers. The formula for DSO is given as:

Days of Sales Outstanding (DSO) = 365 days / Receivables Turnover

where Receivables Turnover = Revenue / Average Receivables

USD millions 2013 2014 Average
Revenue  n/a 473,076.0  n/a
Accounts Receivables 6,677.0 6,768.0 6,722.5
Receivables Turnover  n/a 70.4  n/a
DSO (days)  n/a 5.2  n/a

Source: Walmart Annual Report Data

Based on the calculations above, Walmart takes approximately 5.2 days to collect its cash after customers purchased their goods.

 

Days of Inventory Outstanding

The Days of Inventory Outstanding (DIO) calculates the number of days inventories sit on the shelves before being picked up by customers. The lower the ratio, the better. The formula for DIO is given as:

Days of Inventory Outstanding = 365 days / Inventory Turnover

where Inventory Turnover = Cost of Goods Sold / Average Inventory

USD millions 2013 2014 Average
Cost of Goods Sold  n/a 358,069.0  n/a
Inventories 43,803.0 44,858.0 44,330.5
Inventory Turnover  n/a 8.08  n/a
DIO (days)  n/a 45.2  n/a

Source: Walmart Annual Report Data

Based on the calculations above, Walmart takes approximately 45.2 days to sell its inventories.

 

Days of Payables Outstanding

The Days of Payables Outstanding (DPO) measures the number of days a company takes to pay its suppliers. It is advantageous for companies to stretch out their duration before paying for its inventories as it allows a form of “free” financing. However, an investor should watch out if the DPO extends for too long as it may be a sign of an inability to make payments. The formula for DPO is given as:

Days of Payables Outstanding (DPO) = 365 days / Payables Turnover

where Payables Turnover = Purchases / Average Payables

USD millions 2013 2014 Average
Purchases  n/a 359,124.0  n/a
Accounts Payables 38,080.0 37,415.0 37,747.5
Payables Turnover  n/a 9.51  n/a
DPO (days)  n/a 38.4  n/a

Source: Walmart Annual Report Data

Based on the calculations above, Walmart takes approximately 38.4 days to pay its suppliers.

 

By adding up the DSO, DIO and DPO we get a CCC of only 12 days! That is pretty efficient for a supermarket. Based on our result, we can analyze what are the driving factors which allow Walmart to be so efficient in their net operating cycle. Analyzing the DSO, DIO and DPO allows investors to understand which independent variable has caused the CCC to improve or lag behind its competitors. A historical trend line could be built to investigate how a company has managed its cash collection over the years.

 

Value in Action

The Cash Conversion Cycle is a useful way to track a company’s cash generation efficiency, driven by the DSO, DIO and DPO. The lower the CCC, the better as this allows a company to generate cash quickly.

 

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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie doesn’t own shares in any companies mentioned above.


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