Cash conversion cycle . The Cash Conversion Cycle, which can be homologated with the term of cash or cash cycle, is essential for the administration of working capital. It is the period of time that elapses from the payment for the purchase of the raw material to the collection of the accounts receivable generated by the sale of the final product.
Summary
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- 1 Background
- 2 Cycle theory
- 1 Component cycles
- 3 Strategies
- 1 Inventory cycle
- 2 Collection cycle
- 3 Payment cycle
- 4 Sources
- 5 See also
Background
Current assets , commonly called working capital, represent the portion of investment that circulates in one form or another in the ordinary course of business. This idea encompasses the recurring transition from cash to inventory, to accounts receivable, and back to cash. The lack of synchronization of inflows and outflows of money gives rise to the need for working capital, an aspect related to the duration of the cash conversion cycle.
Cycle theory
Among the most important issues of proper operational financial management in companies is undoubtedly the management of current activity. The money order turnover depends on the structural characteristics of the company and the variability of the general conditions of the economic system. This average period will tend to remain constant as long as these conditions do not vary.
The time the cycle lasts must be financed by the company; the longer the period, the greater the amount of funds required to maintain the operation of the entity.
A positive cash conversion cycle means that the company must use negotiable liabilities (such as bank loans) to keep its assets operating, so it is essential to shorten the days of the cycle whenever conditions allow with a view to requiring fewer external funds .
This gap can be reduced by various actions:
- Accessing bank loans.
- Reducing inventory periods.
- Accelerating collections.
- Obtaining longer credit terms from the suppliers.
These principles of action are precisely those that help maintain acceptable levels in current accounts, without affecting the liquidity of the company.
Component cycles
The cash cycle (EC) is determined by three basic liquidity factors:
- Inventory Conversion Period (CI)
- The accounts receivable (CC) conversion
- The deferral of accounts payable (CP)
The first two, called the operating cycle, indicate the time during which the company’s current assets are frozen; This is the term necessary for the cash to be converted into inventory, which in turn is transformed into accounts receivable, which in turn are converted back to cash.
The third indicates the time during which the company will have the use of funds from the providers before they require payment.
The formula for its calculation is:
CE = CI + CC – CP
Strategies
There are several strategies to minimize the cash cycle through its component cycles.
Inventory cycle
The inventory cycle is basically the time it takes for the raw materials and materials available for the production or service provision process to become finished products. The strategies or measures that could be taken into account for its reduction will be mainly aimed at:
- Use the ABC system for the inventory control and selection process following the Pareto principle. This technique will allow the location of the inventory lines by areas of importance depending on the contribution to sales.
- Apply optimal inventory modeling techniques to determine the required quantity looking for the minimum costs. This technique can be applied to the lines that classify in zone A.
- Review the entire sourcing process focused on acquisition prices, commercial credit terms offered by suppliers, and evaluation of price reductions.
- Achieve stable contracts with providers that offer the best credit terms. At this point, the entity must obtain and keep its star suppliers, those who ensure essential raw materials and who must receive special treatment.
- Contemplate the state of conservation of the inventory to avoid losses in sales, idle and slow-moving inventories.
- Know in depth the operation of the company that allows to establish an average of rotation of all the lines.
- Maintain an efficient distribution system.
- Promote quality in productions and services that ensure inventory turnover, efficiency, effectiveness and effectiveness of the company.
Collection cycle
The collection cycle is nothing more than the time it takes for the company to collect its accounts receivable after making its sales on credit. The collection process is the part that secures the cash inflows from the fundamental operations.
The analysis of accounts receivable depends on the commercial credit policy applied by each entity with a view to increasing or reducing its sales. This policy is based on variables that will be controlled for those purposes and will be closely linked to the financial conditions and the discipline of payment of the clients in the fulfillment of the contractual terms. It can also be based on a study of the average collections to clients by age, these in turn determine the collection patterns that the company will contemplate in the preparation of its cash budget.
The fundamental measures to reduce the collection cycle would be aimed at:
- Differentiate customers according to the age of their accounts. At this point you should work closely with the age report of the accounts by age.
- Be more rigorous in the selection of clients.
- Emphasize the variable credit standards that is where credit quality is evaluated.
- Establish cash discounts to customers to encourage prompt payment.
- Make the reconciliations before the invoices are due so that the clients assume the entire amount of their debts.
- Execute a quick collection management (30 days) with the best clients, and give special treatment to those who qualify as more delinquent. Without losing market in high pressure techniques.
- Apply late payment surcharges established in commercial credit contracts.
- Use the instruments established by the Central Bank of Cuba to streamline the collection process.
Payment cycle
The payment cycle will be the time it takes the company to pay its accounts payable after having made the payment of its raw materials and labor. Extended payment cycles ensure shorter cash cycles, this condition is favorable for companies as long as the deferral of their short-term commitments does not interrupt the supply chain, and therefore the lack of inventory does not impede production programs and customer service.
The measures aimed at reversing this payment situation are the following:
- Differentiate accounts payable by age according to the balance aging report.
- Pay aging balances avoiding penalties for late payment and loss of business image.
- Increase the payments that are allowable to the different providers in change documents up to 60 days.
- Carry out the established reconciliations.
- Evaluate the prompt payment discounts offered by providers and compare them with alternative financing sources.
- Take advantage of discounts whenever it is economically feasible.
