Literature review

Cash conversion cycle

Cash conversion cycle measures how fast a company can convert cash in hand into even more cash in hand. The cash conversion cycle is a process that is used to evaluate the current financial stability of a business. It is identifying of the number of days it takes from the acquisition of the raw materials used to create products all the way through, to the time that payment is received for the manufactured goods. The Net operating cycle is referred to as Cash Conversion Cycle. There is an operating cycle always involved in the conversion sales into cash. There is a difference between current and fixed assets in terms of their liquidity. A firm requires many years to recover the initial investment in fixed assets such as plant and machinery or land and buildings. But investments in current assets are turned over many times in a year. Investment in current assets such as inventories and debtors (accounts receivable) is realized during the firms operating cycle that is usually less than a year. So, operating cycle is the time duration required to convert sales, after the conversion of resource into inventories, into cash. There are three phases included in the operating cycle: Acquisition of resources (raw material, labour, power etc), manufacture of the product (conversion of raw materials into work in progress), and sale of the product (cash or on credit). The length of the operating cycle of a manufacturing firm is the sum of Inventory Conversion Period (ICP) and Debtors (receivable) Conversion Period (DCP). The inventory conversion period is the total time needed for producing and selling the product. It includes Raw Materials Conversion Period (RMCP) Work in progress conversion period (WIPCP) and Finished goods conversion period (FGCP). The Debtors conversion period is the time required to collect the outstanding amount from the customers. The total of inventory conversion period and Debtors conversion period is referred to as Gross Operation period. The Creditors (payables) deferral period (CDP) is the length of time the firm is able to defer payment on various resource purchases. The difference between (gross) operating cycle and payable deferral period is net operating cycle (NOC). If depreciation is excluded from expense in the computation of operating cycle, the net operating cycle also represents the Cash Conversion Cycle (CCC). It is net time interval between cash collections from sale of the product and cash payments for resource acquired by the firm. It also represents the time internal over which additional funds called working capital, should be obtained in order to carry out the firms operations. The firm has to negotiate working capital from sources such as commercial banks. The DC School of Management And Technology Page 1

negotiated sources of working capital finance financing are called non-spontaneous sources. If net operating cycle of firm increases, it means further need for negotiated working capital.

Gross operating cycle = Inventory conversion period + Debtors conversion period

GOC = ICP + DCP . (1)

Inventory conversion period (ICP) ICP is the sum of raw material conversion period (RMCP), Work in progress conversion period (WIPCP) and finished goods conversion period (FGCP) ICP = RMCP + WIPCP + FGCP (2)

Raw material conversion period (RMCP) RMCP is the average time period taken to convert material in to work in process. RMCP depends on raw material consumption per day & raw material inventory. Raw material consumption per day is given by total raw material consumption divided by the number of days in the year (say, 360). The raw material conversion period is obtained when raw material inventory is divided by raw material consumption per day. Similarly calculation can be made for other inventories, debtors and creditors. The following formula can be used: RMCP = Raw material inventory / [raw material consumption]/360 (3)

Work in process conversion period (WIPCP) : WIPCP is the average time taken to complete the semi-finished or work in- process. Work in process conversion period = work-in-process inventory/ [cost of production]/360... (4)

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Finished goods conversion period (FGCP) Finished goods conversion period is the average time taken to sell the finished goods. Finished goods conversion period = Finished goods inventory / [Cost of goods sold / 360].. (5)

Debtors (receivable) conversion period (DCP) DCP is the average time taken to convert debtors into cash. DCP represents the average collection period.

Debtors conversion period (DCP) = Debtors / [Credit sales / 360] (6)

Creditors (payable) deferral period (CDP) CDP is the average time taken by the firm in paying its suppliers (creditors). CDP = Creditors / [credit purchases /360] (7)

Cash conversion Or Net operating cycle Net operating cycle [NOC] is the difference between gross operation cycle and payable deferral period. Net operating cycle = Gross operating cycle Creditor deferral period. (8) NOC = GOC CDP

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