Cash Conversion Cycle: What Goes Around Comes Around

Introduction: Help Me Help You

              American poet Ralph Waldo Emerson observed, “No man can help another without helping himself.” Sometimes bankers can help borrowers when they help themselves, and the cash conversion cycle (CCC) is a great self-help example. Sure, lenders need to get a sense of how long it takes a borrower to cycle cash through its business, but the metrics employed to measure that time can also help the borrower manage its own working capital. Justin Timberlake’s 2006 What Goes Around . . . Comes Around captures this spirit, “What goes around, goes around, goes around, Comes all the way back around.” So, let’s examine the CCC to see how it works its way around.

CCC: Cashing In

Current assets might not make the world go round, but they keep most businesses running only as long as they stay current. So, the faster that the borrower’s cash can pay suppliers for inventory, the faster the inventory can be sold to customers, and the faster that the cash proceeds can be collected from client receivables, the more bankable the borrower. On the other hand, paying suppliers slowly tends to diminish supplier credit, slow-turning inventory runs the risk of style or technological obsolescence or just plain physical deterioration, and past-due receivables threaten possible charge-off. Reliance on liquidity measures like the current ratio ignore the time risk; a current ratio of 2.0x might simply mean that the borrower’s stale inventory and past-due receivables are twice as much as its past-due trade credit and non-accrual bank loan. After writing down unsaleable inventory and charging off bad receivables, the borrower is unlikely to be able to pay either its suppliers or its banker. So how do we identify, monitor, and manage the cycle risk?

First, let’s define CCC as the sum of days receivable plus days inventory minus accounts payable. A positive CCC indicates the number of days a borrower must borrow or rely on its own capital while waiting for its customers to pay their invoices. A negative CCC tells us the number of days of customer cash the borrower has accumulated before it has to pay its suppliers. Therefore, a strong borrower has a low positive CCC or a negative CCC.

Second, the days measure is really just the inverse of the turnover ratio. For example, if a borrower’s inventory turns over 6 times a year, that means the borrower carries a 61-day supply of inventory (365 days/6 times = 61 days), or said another way, the borrower is stuck with the inventory and all its related carrying costs, e.g., security, storage, utilities, etc., for the 61-day period. Naturally, the faster the turnover, the fewer the number of days on hand and the lower the carrying costs.

Third, the calculations vary slightly between days receivable and days inventory and days payable. Days receivable is calculated based on sales, i.e., [(days receivable = accounts receivable)/revenue x 365 days], but the other two measures use cost of goods sold (COGS) because the cost of inventory purchased from suppliers is the primary component of COGS [days inventory = (inventory/COGS) x 365 days], [days payable = (accounts payable/COGS) x 365 days]. Using revenue instead of COGS would add gross profit to the mix and understate the number of days. 

For example, budding marijuana wholesaler Ridgemont High scored $1mm in revenues last year and a 25% gross profit margin yielding a $250M gross profit. Its fiscal year-end (FYE) inventory rolled up to $500M, its accounts payable stemmed at $300M, and receivables mellowed out at $250M. Days receivable are easy enough—approximately 91 days ($250/$1,000M x 365 days = 91.2 days). In contrast, based on revenues, its days inventory is around 182 days ($500M/$1,000M x 365 days = 182.5 days), but based on COGS, its days inventory rounds out around 243 days ($500M/$750M x 365 days = 243 days).  Revenue-based days inventory incorrectly shortens the number of COGS-based days by a couple of months. Likewise, the difference in days payable is also substantial—36 days or so ($300/$1,000M x 365 days = 109.5 days vs. $300M/$750M x 365 days = 146 days).

So, the banker calculating CCC on just revenues is going to overestimate the cycle speed by some 61 days for inventory and 36 days for payables—these are not fast times for Ridgemont High:

Measure            days receivable + days inventory - days payable   =  total days

Revenue                     92                           82                      110                          164

Rev & COGS             92   243 146 189

Difference                    0                            61                       36                             25

The good news is that trade debt is an alternative funding source, so the extra 36 days is 36 days of working capital asset support the banker doesn’t have to cover. The bad news is twofold, first, trade debt is much more expensive than bank debt, and this much trade debt is likely to have burned up Ridgemont High’s trade credit capacity and made an ash of its credit reputation. Typical 2/10 net 30-day terms work out to a 36.5% annual rate (2%/20 days x 365 days), and any customer who pushes 30-day terms out to 146 days is likely to be on cash only terms until brought current. 

A thoughtful lender might point out to RH’s principals that they need to get their heads out of the clouds and back down to earth. Sage counsel might start with RH’s internal measures.  First, if RH extends 30-day terms to its customers, 92 days suggests RH needs tighter credit and collections. Second, 243 days of inventory is an expensive investment, especially given the fragility of its product, so lower levels would free up considerable working capital dollars. Third, those extra working capital dollars would be well spent to pay down its excessive trade debt.

Banks rely on industry statistics such as Risk Management Association’s RMA’s) annually published Statement Studies (www.rmahq.org), and many industry associations offer similar data. Suppose industry statistics indicate that average days receivable run about 40 days, days inventory around 75 days, and days payable approximately 25 days. That adds up to an industry CCC of 90 days (40 + 75 – 25 = 90), considerably faster than RH’s flaky 189 days. The shorter industry average’s 90-day period means far less pressure on a line of credit than RH’s 6-month CCC. In fact, if RH were able to just achieve the industry averages, it would free up $237M ($450 - $213 = $237) of working capital, almost enough to pay off RH’s $249M ($300M - $51M) ofexcessive trade debt and restore its credit reputation:

NWC     FYE $M    Industry Averages    $M Amt Needed for NWC Items

AR    $250              40 days                 40 days = AR/$1,000 x 365 days = $110

INV        $500              75 days                 75 days = Inv/$750 x 365 days =   $154

AP          $300               25 days                 25 days = AP/$750 x 365 days =     $51

Net $450 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $213                                                                                                      

Summary and Closing: Help Yourself 

Showman P.T. Barnum advised, “Fortune always favors the brave, and never helps a man who does not help himself.” It takes both a brave banker and a brave borrower to identify, monitor, and manage the CCC. Nevertheless, as a trusted financial advisor, the banker can show the borrower where the levels ought to be, and as a creditworthy client, the borrower can demonstrate the willingness and ability to tighten credit, trim inventory, and pay suppliers promptly. The challenge is to get going. As Mark Twain noted, “The secret of getting ahead is getting started.” So, start by helping your borrower get off its assets and get its CCC going faster!