Showing posts with label ccc. Show all posts
Showing posts with label ccc. Show all posts

Wednesday 14 July 2010

Understanding The Cash Conversion Cycle

Understanding The Cash Conversion Cycle

by Jim Mueller
The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower this number is, the better for the company. Although it should be combined with other metrics (such as return on equity and return on assets) it can be especially useful for comparing close competitors because the company with the lowest CCC is often the one with better management. In this article, we'll explain how CCC works and show you how to use it to evaluate potential investments. 
What Is It?
The CCC is a combination of several activity ratios involving accounts receivable, accounts payable and 
inventory turnover. AR and inventory are short-term assets, while AP is aliability; all of these ratios are found on the balance sheet. In essence, the ratios indicate how efficiently management is using short-term assets and liabilities to generate cash. This allows an investor to gauge the overall health of the company. (For further reading, see Reading The Balance Sheet andIntroduction To Fundamental Analysis: The Balance Sheet.)

How do these ratios relate to business? If the company sells what people want to buy, cash cycles through the business quickly. If management cannot figure out what sells, the CCC slows down. For instance, if too much
inventory builds up, cash is tied up in goods that cannot be sold - this is not good news for the company. In order to move out this inventory quickly, management might have to slash prices, possibly selling its product at a loss. If AR is handled poorly, it means that the company is having difficulty collecting payment from customers. This is because AR is essentially a loan to the customer, so the company loses out whenever customers delay payment. The longer a company has to wait to be paid, the longer that money is unavailable for investment elsewhere. On the other hand, the company benefits by slowing down payment of AP to its suppliers, because that allows the company to make use of the money for longer. (To learn more, read Measuring Company Efficiency and Understanding The Time Value Of Money.) 




The Calculation
To calculate CCC, you need several items from the financial statements:
  • Revenue and cost of goods sold (COGS) from the income statement
  • Inventory at the beginning and end of the time period
  • AR at the beginning and end of the time period
  • AP at the beginning and end of the time period
  • The number of days in the period (year = 365 days, quarter = 90)


    Inventory, AR and AP are found on two different balance sheets. If the period is a quarter, then use the balance sheets for the quarter in question and the ones from the preceding period. For a period of a year, use the balance sheets for the quarter (or year end) in question and the one from the same quarter a year earlier.

    This is because, while the 
    income statement covers everything that happened over a certain period of time, balance sheets are only snapshots of what the company was like at a particular moment in time. For things like AP, you want an average over the period of time you are investigating, which means that AP from both the time period's end and beginning are needed for the calculation.

    Now that you have some background on what goes into calculating CCC, let's take a look at the formula:



    CCC = DIO + DSO - DPO

    Let's look at each component and how it relates to the business activities discussed above.Days Inventory Outstanding (DIO): This addresses the question of how many days it takes to sell the entire inventory. The smaller this number is, the better.


    DIO = Average inventory/COGS per day
    Average Inventory = (beginning inventory + ending inventory)/2

    Days Sales Outstanding (DSO): This looks at the number of days needed to collect on sales and involves AR. While cash-only sales have a DSO of zero, people do use credit extended by the company, so this number is going to be positive. Again, smaller is better.


    DSO = Average AR / Revenue per day
    Average 
    AR= (beginning AR + ending AR)/2

    Days Payable Outstanding (DPO): This involves the company's payment of its own bills or AP. If this can be maximized, the company holds onto cash longer, maximizing its investment potential; therefore, a longer DPO is better.


    DPO = Average AP / COGS per day
    Average AP = (beginning AP + ending AP)/2

    Notice that DIO, DSO and DPO are all paired with the appropriate term from the income statement, either revenue or COGS. Inventory and AP are paired with COGS, while AR is paired with revenue.
    Practical ApplicationLet's use some real numbers from a retailer as an example to work through. The data below is from Barnes & Noble's 10-K reports filed for the fiscal years ending January 28, 2006 (fiscal year 2005) and January 29, 2005 (fiscal year 2004). All numbers are in millions of dollars.


    Item
    Fiscal Year 2005Fiscal Year 2004
    Revenue5103.0Not needed
    COGS3533.0Not needed
    Inventory1314.01274.6
    A/R99.191.5
    A/P828.8745.1
    Average Inventory( 1314.0 + 1274.6 ) / 2 = 1294.3
    Average AR( 99.1 + 91.5 ) / 2 = 95.3
    Average AP( 828.8 + 745.1 ) / 2 = 787.0

    Now, using the above formulas, CCC is calculated:




    DIO = $1294.3 / ($3533.0 / 365 days) = 133.7 days
    DSO = $95.3 / ($5103.0 / 365 days) = 6.8 days
    DPO = $787.0 / ($3533.0 / 365 days) = 81.3 days
    CCC = 133.7 + 6.8 - 81.3 = 59.2 days



    What Now?
    As a stand alone number, CCC doesn't mean very much. Instead, it should be used to track a company over time and to compare the company to its competitors.

    When tracking over time, determine CCC over several years and look for an improvement or worsening of the value. For instance, for fiscal year 2004, Barnes & Noble's CCC was 68.9 days, so the company has shown an improvement between the ends of fiscal year 2004 and fiscal year 2005. Barnes & Noble achieved this improvement by decreasing DIO by 4.5 days, increasing DSO by 1.5 days and increasing DPO by 6.7 days. While between these two years the change is good, the slight increase in DSO might merit more investigation, such as looking further back in time. CCC changes should be examined over several years to get the best sense of how things are changing.

    CCC should also be calculated for the same time periods for the company's competitors, such as Borders Group and Amazon.com. For fiscal year 2005, Borders' CCC was 101.2 days (168.4 + 12.0 - 79.2). Compared to Borders Group, Barnes & Noble is doing a better job at moving inventory (lower DIO), is quicker at collecting what it is owed (lower DSO) and keeps its own money a bit longer (higher DPO). Remember, however, that CCC should not be the only metric used to evaluate either the company or the management; 
    return on equityand return on assets are also valuable tools for determining the effectiveness of management. (For more insight, check out Keep Your Eyes On The ROEUnderstanding The Subtleties Of ROA Vs. ROE and ROA On The Way.) 

    Interestingly, Amazon's CCC for the same period is 
    negative,coming in at -31.2 days (29.6 + 10.2 - 71). This means that Amazon doesn't pay its suppliers for the books that it buys until after it receives payment for selling those books; therefore, Amazon doesn't have a need to hold very much inventory and still hold onto its money for a longer period of time. Although online retailers have this advantage, there are other issues that keep Borders and Barnes & Noble in the game. After all, you cannot curl up in those comfortable chairs with a fresh latte at Amazon - despite Amazon's success, there is still something to be said for the experience of going to a bookstore.





    Wrapping It Up
    The cash conversion cycle is one of several tools that can help you evaluate management, especially if it is calculated for several consecutive time periods and for several competitors. Decreasing or steady CCCs are good, while rising ones should motivate you to dig a bit deeper.

    CCC is most effective with retail-type companies, which have inventories that are sold to customers. Consulting businesses, software companies and insurance companies are all examples of companies for whom this metric is meaningless. 


    For additional reading, see 
    Using The Cash Conversion Cycle and Cash 22: Is It Bad To Have Too Much Of A Good Thing?
     


    by Jim Mueller
    Jim Mueller started his career as a scientist, earning his advanced degree in biochemistry and molecular biology from Washington State University. He has since become a self-taught investor and financial writer. He is also a regular contributor to The Motley Fool.


    Also read:
    Cash Conversion Cycle
    http://en.wikipedia.org/wiki/Cash_conversion_cycle