Question

9. Explain the components of the cash cycle and how changes in these components can increase or decrease the cash cycle. What is preferable a negative or positive cash cycle? Why?

Answer 1

Cash cycle or Cash conversion cycle (CCC), in simple terms, is the time taken for the company to convert the raw materials to cash. It indicates the number of days between payment done to vendors (for purchasing raw materials/inventory) and receipt of cash. It tells the ability of the company in terms of how quickly it can realize cash from the investments made in inventory. This is a key indicator of how a company efficiently manages its working capital.

Formula:

Cash cycle = Days inventory outstanding (DIO) + Days Sales outstanding (DSO) - Days payables outstanding (DPO)

Days Inventory outstanding (DIO) = (Average Inventory/Cost of Goods sold)*365. This gives the number of days a company takes to sell its inventories

Days Sales outstanding (DSO) = (Average Account receivables/Total credit sales)*365.. This gives the number of days a company takes to collect cash from sales.

Days Payables outstanding (DPO) = (Average accounts Payables/Cost of Goods sold)*365. This gives the number of days a company takes to pay its suppliers

Positive cash cycle: If cash cycle is less, it means the company is able to realize cash quickly. If the cash cycle is more, it means it takes more number of days to realize cash.

Negative cash cycle: Sometimes, cash cycle can be negative. Negative cash cycle means that company is receiving cash even before it is making vendor payments. This scenario is possible for online retailers, where they realize cash from customers immediately (DSO=0 or less) as there is no or limited credit sales and immediate realization of money) and they don't hold any inventory (DIO=0), and they can pay the vendors later based on agreements.