Working Capital: Cash Conversion Days
Hello,
I am looking at a company's cash conversion cycle, per below:
Days Receivables + Days Inventory - Days Payable = Cash Conversion Cycle (days)
Any thoughts how changes in this cycle (from one period to the next) influence cash and debt balances? If for example we go from 50 days in a period to 55 days, there are 5 more days to finance. So here net debt should go up, correct? Any thoughts for discussion would be great!
Think about it as an equation... X+Y-Z = Change in Cash Collection. Measures of efficiency: collecting receivables, managing inventory, and paying accounts payable.
Debt isn't directly a part of what you're trying to capture in this measure... working capital changes are. So let's say that the company loses cash collection efficiency (gains 5 days, per your post). This can happen because of decreased efficiency collecting receivables, decreased efficiency in inventory management, or decreased efficiency in paying A/P. The first two would be represented by an increase in a current asset, either inventory or receivables, relative to sales. The second would be represented by a current liability, accounts payable, decreasing relative to sales.
WC is more important when thinking through what these operating metrics really mean. That being said, the change in WC (due to becoming less efficieny) would cause cash on the B/S to go down or additional revolver capacity to be used, so net debt would go up. In the opposite scenario, increased WC efficiency would cause cash on the B/S to go up or less revolver capacity being used, and net debt would go down.
To add you can specifically calculate the effect on balance sheet as each part of WC cycle changes.
A/r dso increase so current assets (a/r) consequently increase. Assets go up so you know liabilities or equity needs to go up (or assets to go down). As a/r is wc, you know its being financed by current liabilities, most often by greater revolver utilization.
Same thing with inventory.
Wc is really important cash flow driver, if you take a look at a firm such as mcdonalds that is a cash flow generation machine; the reason is business model requires few a/r, inv, a/p so cash flow isn't trapped there.
You can calculate the effect on cash flow based on change in a/r, inv, a/p days as well as impact of sales growth...a/r days increase by 5...what is increase in current assets (source of cash) due to this? Etc, the formulas are easy enough to look up and do on a paper napkin.
Thanks, your explanations are helpful, it confirms that net debt should go up during the period to fund the additional WC days. But, net debt actually goes down over the same period. So how is this possible? On the cash flow statement we have:
Cash from Operating Activities: the WC movements are captured in here, along with other (perhaps explanatory) changes.
Cash from Financing Activities: Debt is going down, when we would expect it would go up to fund the WC needs.
So shall we look at line items in Cash from Investing Activities and Cash from Operating Activities for inflows to explain the ability to reduce net debt over the same period, when Cash Conversion Cycle days are up?
Thanks!
working capital change is just one of several variables that affect cash flow and cash balances...
Keep in mind that these are all relative to sales/COGS... if your sales number is changing without significant changes in WC, you could see the cash conversion cycle expand without significant balance sheet changes.
Working Capital Days (Originally Posted: 08/11/2013)
Hi I'm a rising junior here trying to learn as much about accounting concepts through self-study. Can someone please help me understand why when calculating working capital days, accounts receivable is driven by sales, while inventory days and accounts payable are driven by COGS? Also, other there other balance sheet items that should go into working capital calculations (like prepaid expenses)? If so, what is the underlying logic?
Thank you.
DSO is driven by sales, as Accounts receivable represent a cash inflow and are effectively contributing to total revenue. DPO and DSI are both driven by COGS as they both represent measure of cash outflow and literally what it costs the firm to acquire inventory and sell it.
An easy way to think about Net Working Capital would be like this:
(Current Assets - Cash) - (Current Liabilities - Debt) = NWC
What you include in the end for NWC and how you forecast each item is depending on whoever does the model.
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