Thread by @ValueEducator

How to interpret the cash conversion cycle?

A short thread 🧵🧵 with examples !!

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Before understanding cash conversion cycle we should understand what are inventory days, debtor days and payable days.

Firstly let's look at its formula and then will look at its interpretation.

Cash conversion cycle is calculated as Inventory days + Debtor days - payable days. Inventory days + Debtor days is known as operating cycle.

Now lets understand what are inventory days, debtor days and payable days

Inventory days:
In any manufacturing business, raw materials are required. Firstly the raw materials are bought, then they are stored in the warehouse.

Then the raw materials are processed to make the final product and then the final product is sold to the customers. The number of days required from bringing the raw materials to selling the final product to the customer is known as inventory days.

Debtor days:
After selling the final product to the customer cash is not received immediately but within a specific number of days. These are called debtor days. Inventory days along with debtor days is known as operating cycle.

Payable days:
The number of days in which the company needs to make the payment to the raw material supplier is known as payable days.

Now let’s understand this with some examples.

Case 1: #AstralPipes

If we check in the case of Astral Pipes its inventory days are 91. This means that 91 days are required by the company from bringing raw materials and then selling the final product to the customer.

Debtor days are 22. So the company gets the money from its debtor in another 22 days. So its operating cycle is 91+22 = 113. So basically the company requires 113 days from bringing raw materials till getting money from the customer.

The company’s payable days are 93 which means that the company needs to make payment to its supplier in 93 days. So the company needs to make payment to the supplier in 93 days

but it will get money from its debtor in 113 days the company won’t be having cash in hand in those 20 days (113-93) which is basically the cash conversion cycle. So it may use debt for its working capital management in those 20 days.

Case 2: #NestleIndia

If we check in the case of Nestle its inventory days are 111. This means that 111 days are required by the company from bringing raw materials and then selling the final product to the customer. Debtor days are 4.

So the company gets the money from its debtor in another 4 days. So its operating cycle is 111+4= 115.So basically the company requires 115 days from bringing raw materials till getting money from the customer.

The company’s payable days are 122 which means that the company needs to make payment to its supplier in 122 days. So the company needs to make payment to the supplier in 122 days but it will already get money from its debtor in 115 days.

So the company has a buffer of 7 days to make its payment to the supplier. Therefore Nestle India has a cash conversion cycle of -7. Negative cash conversion cycle is a best case scenario for any company.

Nestle India enjoys a negative cash conversion cycle because it is a market leader in most of its segments and it has high bargaining power with its suppliers.

For Nestle India it doesn't matter from which supplier it is sourcing but for the suppliers Nestle India is a very big client so high volumes are supplied to Nestle India. Therefore suppliers don't have bargaining power. Therefore Nestle India has a negative cash conversion cycle

Conclusion:

Lower the cash conversion cycle means that the company is managing its working capital efficiently. So basically the cash conversion ratio is lower the better.

Some companies which have high bargaining power with the suppliers and are market leaders have a negative cash conversion cycle as we saw in the case of Nestle India. A negative cash conversion cycle is one of the best case scenario a company can have.

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