Question

Why might a company want to reduce its cash conversion cycle and what are the financial implications of reducing the cash cycle? Can you think of a reason why a company may NOT want to reduce the cash cycle? Please answer in 2-3 paragraphs

Answer 1

The cash conversion cycle is a process that expresses the time taken for a company to convert its investments in inventory and other resources into cash flows from sales. It is also called the Net Operating Cycle or Operating cycle. It takes into account how much time the company needs to sell its inventory, how much time it takes to collect receivables, and how much time it has to pay its bills without incurring penalties.

The company might opt to reduce its cash conversion cycle due to following reasons:

1. To improve Cash Flow Management
2. To collect Accounts Receivables Faster
3. To improve Accounts Receivables Process
4. To disburse accounts payable more slowly
5. To manage inventory more efficiently
6. To take advantage of bank’s treasury management services

The financial implications on reducing the cash conversion cycle would be:

1. Free up receivables early
2. More availability of cash to pay or invest due to shorter conversion period
3. Continued operations cycle without obtaining excess credit

However, the company may not sometimes opt to reduce the cycle due to following reasons:

1. If the cost of purchase of materials inventory to company is lower if purchased in bulk quantities, then company may opt to invest cash in inventories.
2. In case of deflationary situations
3. In order to secure trust of debtors and with a view of expansion companies may allow extra credit period turning slower receivables.

However, it's better for the company to have a shortercycle rather than a long cash conversion cycle.