Have you ever walked into a store and wondered how they paid to fill it with products to sell? The easy answer might be, "with the money they made from the things they sold last month," and that's partially true, but what about for brand new stores? There's probably millions of dollars of inventory on the floor of many large retailers and hundreds of thousands of dollars of inventory on the floor of many small businesses. This working capital must be paid for - but how?
Many companies will take on debt to finance their inventories. Suppliers, eager to get business, will often offer credit terms, and each company decides how and when to take advantage of these through maintaining an Accounts Payable balance. This gap between paying for the products and receiving the money for selling them is called the cash conversion cycle.
Cash Conversion Cycle: the amount of time that passes between when a company spends money to buy an item and when they receive the money for selling it.
To calculate the cash conversion cycle, take the average number of days it takes to sell inventory, plus the average number of days it takes to receive payment for that sold inventory, minus the average number of days before paying for received inventory. In terms of accounting ratios, this is:
Cash Conversion Cycle = Days Inventory + Days Receivables – Days Payables
A typical company receives inventory, pays later for that inventory, sells the inventory, then receives payment for it.
The implications of the cash conversion cycle are powerful. To illustrate with an example, imagine a company that buys t-shirts for $10 and sells them for $15 – a very simple business. If they have a cash conversion cycle of seven days, this implies that for one week they have lost the $10 needed to purchase each t-shirt but have not yet received the $15 for selling them. Where do they get money to buy more t-shirts and maintain their inventory?
Financing this time through debt can impose a considerable cost on the company, especially for companies with very long cash conversion cycles. The longer the cash conversion cycle, the higher the interest paid on the debt.
Imagine a company that has a negative cash conversion cycle, like Amazon. By selling inventory quickly (low Days Inventory), receiving payment immediately for most sales (low Days Receivables) and putting off payment to suppliers for as long as possible (high Days Payables), their Cash Conversion Cycle is negative.
That means that Amazon actually gets paid for items they sell before they pay for them themselves. So, instead of paying interest to buy items for sale, they are receiving interest by holding cash in their bank account (or investing it in growing their company). This produces a powerful engine for cash generation and growth.
To learn more about the cash conversion cycles of Amazon and other organizations, take a look at this article from Forbes.
Interested in learning more about accounting as well as analytics and economics?
About the Author
Brian is a member of the HBX Course Delivery Team and is currently working to design a Finance course for the HBX platform. He is a veteran of the United States submarine force and has a background in the insurance industry. He holds an MBA from McGill University in Montreal.