Cash conversion cycle

Presented By:
Yaser Ali Hassan
Awais Sharif
Kamar Farooq
Nadeem Nazir

Working Capital &
Current Asset
Management

Net Working Capital
 Working Capital includes a firm’s current
assets, which consist of cash and marketable
securities in addition to accounts receivable
and inventories.
 It also consists of current liabilities, including
accounts payable (trade credit), notes payable
(bank loans), and accrued liabilities.
 Net Working Capital is defined as total current
assets less total current liabilities.

The Cash Conversion Cycle
 Short-term financial management—managing current assets
and current liabilities is one of the financial manager’s most
important and time-consuming activities.
 Central to short-term financial management is an
understanding of the firm’s cash conversion cycle.

Cash Conversion Cycle
Inventory turnover ratio (IT):
3.56
IT = Cost of Goods = 131,924
=
37,009
Inventory
102 days
Inventory Days = 365 = 365
=
3.56
IT

 Accounts receivable turnover (ART):
9.05
ART = Sales = 169,565
=
18,735
Acct. Rec.
40 days
Average Collection Period = 365 = 365
=
9.05
ART

 Accounts payable turnover (APT):
24.22
APT = Cost of Goods = 131,924
=
5,448
Accts. Payable
15 days
Average Payment Period = 365 = 365
=
24.22
APT

Calculating the Cash Conversion
Cycle
 Both the OC and CCC may be computed
as shown below.
OC = Inventory Days + ACP
 OC = 102 + 40 = 142 days
CCC = OC – Average Payment Period
 CCC = 142 – 15 = 127 days

Chromcraft Revington’s Operating Cycle
Average Collection
Average Age of Inventory (AAI) Period (ACP)
Days 0 102 142

Problem # 1
American Products is concerned about managing cash efficiently. On the
average , inventories have an age of 90 days and account receivable are
collected in 60 days . Accounts payable are paid approximately 30 days after
they arise.
 Operating cycle (OC) = Average age of inventories + Average collection period
= 90 days + 60 days
= 150 days
 Cash Conversion Cycle (CCC) = Operating cycle − Average payment period
= 150 days − 30 days
= 120 days

Funding Requirements of the
CCC
 Permanent vs. Seasonal Funding Needs
 If a firm’s sales are constant, then its investment
in operating assets should also be constant,
and the firm will have only a permanent
funding requirement.
 If sales are cyclical, then investment in operating
assets will vary over time, leading to the need for
seasonal funding requirements in addition to the
permanent funding requirements for its minimum
investment in operating assets.

Strategies for Managing the
CCC
1. Turn over inventory as quickly as possible
without stock outs that result in lost sales.
2. Collect accounts receivable as quickly as
possible without losing sales from high-pressure
collection techniques.
3. Manage, mail, processing, and clearing time to
reduce them when collecting from customers
and to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible
without damaging the firm’s credit rating.

Inventory Management:
Inventory Fundamentals
 Classification of inventories:
Raw materials: items purchased for use in
the manufacture of a finished product
Work-in-progress: all items that are currently
in production
Finished goods: items that have been
produced but not yet sold

Inventory Management:
Differing Views About Inventory
 The different departments within a firm (finance,
production, marketing, etc.) often have differing views
about what is an “appropriate” level of inventory.
 Financial managers would like to keep inventory levels
low to ensure that funds are wisely invested.
 Marketing managers would like to keep inventory levels
high to ensure orders could be quickly filled.
 Manufacturing managers would like to keep raw
materials levels high to avoid production delays and to
make larger, more economical production runs.

Techniques for Managing
Inventory
 The ABC System
 The ABC system of inventory management divides
inventory into three groups of descending order of
importance based on the dollar amount invested
in each.
 A typical system would contain, group A would
consist of 20% of the items worth 80% of the total
dollar value; group B would consist of the next largest
investment, and so on.
 Control of the A items would intensive because of the
high dollar investment involved.

Inventory (cont.)
 The Economic Order Quantity (EOQ) Model
EOQ = 2 x S x O
C
 Where:
 S = usage in units per period (year)
 O = order cost per order
 C = carrying costs per unit per period (year)
 Q = order quantity in units

Inventory (cont.)
Assume that KJB, Inc. uses 200 units of an item annually. Its
order cost is $25 per order, and the carrying cost is $1 per unit
per year. Substituting into the above equation we get:
EOQ = 2(200)($25) = 100
$1
The EOQ can be used to evaluate the total cost of inventory
as shown on the following slides.

Inventory (cont.)
Ordering Costs = Cost/Order x # of Orders/Year
Ordering Costs = $25 x 2 = $50
Carrying Costs = Carrying Costs/Year x Order Size
2
Carrying Costs = ($1 x 100)/2 = $50
Total Costs = Ordering Costs + Carrying Costs
Total Costs = $50 + $50 = $100

Inventory (cont.)
 The Reorder Point
 Once a company has calculated its EOQ, it must
determine when it should place its orders.
 More specifically, the reorder point must consider
the lead time needed to place and receive orders.
 If we assume that inventory is used at a constant rate
throughout the year (no seasonality), the reorder point
can be determined by using the
following equation:
Reorder point = lead time in days x daily usage
Daily usage = Annual usage/360

Inventory (cont.)
Using the KJB example above, if they know that it requires 5 days to
place and receive an order, and the annual usage is 200 units per
year, the reorder point can be determined as follows:
Daily usage = 200/360 = 0.56 units/day
Reorder point = 5 x 0.56 = 2.78 or 3 units
Thus, when RIB’s inventory level reaches 3 units, it should place an
order for 100 units. However, if RIB wishes to maintain safety stock
to protect against stock outs, they would order before inventory
reached 3 units.

Inventory (cont.)
 Just-In-Time (JIT) System
 The JIT inventory management system minimizes
the inventory investment by having material inputs
arrive exactly at the time they are needed
for production.
 For a JIT system to work, extensive coordination must
exist between the firm, its suppliers, and shipping
companies to ensure that material inputs arrive on
time.
 In addition, the inputs must be of near perfect quality
and consistency given the absence of safety stock.

Inventory (cont.)
 Computerized Systems for
Resource Control
MRP systems are used to determine what to
order, when to order, and what priorities to
assign to ordering materials.
MRP uses EOQ concepts to determine how
much to order using computer software.
It simulates each product’s bill of materials
structure all of the product’s parts), inventory
status, and manufacturing process.

Accounts Receivable
Management
 The second component of the cash conversion
cycle is the average collection period – the
average length of time from a sale on credit until
the payment becomes usable funds to the firm.
 The collection period consists of two parts:
 the time period from the sale until the customer mails
payment, and
 the time from when the payment is mailed until the
firm collects funds in its bank account.

Accounts Receivable Management:
The Five Cs of Credit
 Character: The applicant’s record of meeting
past obligations.
 Capacity: The applicant’s ability to repay the
requested credit.
 Capital: The applicant’s debt relative to equity.
 Collateral: The amount of assets the applicant
has available for use in securing the credit.
 Conditions: Current general and industry-specific
economic conditions.

Credit Scoring
 Credit scoring is a procedure resulting in a
score that measures an applicant’s overall credit
strength, derived as a weighted-average of
scores of various credit characteristics.
 The procedure results in a score that measures
the applicant’s overall credit strength, and the
score is used to make the accept/reject decision
for granting the applicant credit.

Changing Credit Standards
 The firm sometimes will contemplate changing
its credit standards to improve its returns and
generate greater value for its owners.

Changing Credit Terms
 A firm’s credit terms specify the repayment
terms required of all of its credit customers.
 Credit terms are composed of three parts:
 The cash discount
 The cash discount period
 The credit period
 For example, with credit terms of 2/10 net 30,
the discount is 2%, the discount period is 10
days, and the credit period is 30 days.

Credit Monitoring
 Credit monitoring is the ongoing review of a
firm’s accounts receivable to determine whether
customers are paying according to the stated
credit terms.
 Slow payments are costly to a firm because
they lengthen the average collection period
and increase the firm’s investment in
accounts receivable.
 Two frequently used techniques for credit
monitoring are the average collection period and
aging of accounts receivable.

Credit Monitoring:
Average Collection Period
 The average collection period is the average
number of days that credit sales are outstanding
and has two parts:
 The time from sale until the customer places the
payment in the mail, and
 The time to receive, process, and collect payment.

Credit Monitoring:
Collection Policy
 The firm’s collection policy is its
procedures for collecting a firm’s accounts
receivable when they are due.
 The effectiveness of this policy can be
partly evaluated by evaluating at the level
of bad expenses.
 As seen in the previous examples, this
level depends not only on collection policy
but also on the firm’s credit policy.

Cash conversion cycle

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