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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Cash Conversion Cycle

What it is:

The cash conversion cycle, also called the net operating cycle, is the number of days it takes a company to generate revenues with assets.

How it works (Example):

Analysts can determine the length of the cycle using the following formula:

Cash Conversiion Cycle = Days Inventory Outstanding + Days Sales Outstanding + Days Payables Outstanding

Note that DPO is a negative number.

The cash conversion cycle involves determining how long it takes to create inventory, sell inventory and collect on invoices to customers. For example, let's say Company XYZ makes widgets, which typically sit in the warehouse for 10 days. Let's also assume that it typically takes 15 days to collect on the sale of each widget, and that it takes 14 days to pay invoices to Company XYZ's vendors. Using the formula above, Company XYZ's cash conversion cycle is:

Cash Conversion Cycle = 10 + 15 + -14 = 11 days

This means that Company XYZ generates cash from its assets within 11 days.

Why it Matters:

The cash conversion cycle is a measure of how long an investment is locked up in production before turning into cash.

Changes in cash conversion cycle can be very telling. For example, when companies take an extended period of time to collect on outstanding bills, or they overproduce due to poor estimations, their cash conversion cycles lengthen. For small businesses especially, long cash conversion cycles can mean the difference between profit and bankruptcy. After all, companies can only pay for things with cash, not profits. In turn, the net operating cycle is a measure of managerial competency as well as operational efficiency.

It is important to note that different industries have different capital requirements and standards, and determining whether a company has a long or short cash conversion cycle should be made within that context.

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