An important tool for calculating a company's working capital needs is the Cash Conversion Cycle (CCE). However, some recommendations should be taken into account, such as considering the calculation of the Average Collection Days (DPC) and Average Payment Days (DPP) ratios, always, Total Sales on Credit and Purchases on Credit; In passing, they will allow us to determine if the company is adequately executing its credit policies and complying with the payment to suppliers, within the agreed terms. And, never, finance the entire CCE.
A very common tool, used by Business Officials of Credit Institutions, to assess the liquidity needs of potential borrowers, is the Cash Conversion Cycle (CCE) of the business.
The business cash conversion cycle is made up of three elements:
Average Inventory Days (DPI)
Average Collection Days (DPC)
Average pay days (DPP)
Its formula is as follows:
The interpretation is as follows: If the Average Days of Inventory (DPI) and the Average Days of Collection (DPC) exceed the Average Days of Payment (DPP), the company will have a cash conversion cycle (CCE). In other words, if the days of credit received from suppliers (DPP) are insufficient to finance the credit granted to customers (DPC) and the days the merchandise is kept in warehouses (DPI), the company will have a cycle Cash Conversion (CCE). If so, you will require a loan for working capital, unless you finance your needs with your own resources, that is, with equity (capital and accumulated results).
Example:
There is the case of a company that registers the following information:
- Average Inventory Days (DPI): 60 days Average Collection Days (DPC): 40 days Average Payment Days (DPP): 45 days
Applying formula (1):
In other words, the company generates a Cash Conversion Cycle (CCE) of 55 days, which it has to finance in some way: with its own resources (equity) or with resources from Credit Institutions.
Now, the next step is to convert the 55 days into monetary units, for this we are going to complement the example with the following information:
Annual Sales = $.10'000,000 (100% on credit)
Cost of Sales = 75% of sales
Purchases on credit = 65% of cost of sales
Replacing data:
Inventory = ($.10'000,000 x 0.75) x (60/360) = $.1'250,000
+ Accounts receivable = ($.10'000,000) x (40/360) = $.1'111,111
- Accounts payable = ($.10'000,000 × 0.75 × 0.65) x (45/360) = $. 609,375
= Necessary Resources = $.1'751,736
Therefore, the 55 days of its Cash Conversion Cycle (CCE) will be equivalent to a financing need of $.1,751,736.
Explanation:
Inventory.- If the cost of selling the merchandise is 75% of sales, then the cost of sale will be: $.7'500,000 ($.10'000,000 x 0.75). However, this cost corresponds to the merchandise purchased throughout the year. On the other hand, it is known that the average days of inventories are 60 days, so the merchandise rotates 6 times a year (360/60). That is, the purchase of $.7'500,000 is made in six navies, one every 60 days, of $.1,250,000 each armada.
Accounts receivable.- The average collection days are 35 days. In other words, during the year there are 9 collections (360/35). On the other hand, if sales are entirely on credit, the $.10'000,000 will be collected in 9 navies, each of $.111,111.
Accounts payable.- Average payment days are 40 days. In other words, 8 payments are made during the year (360/45). On the other hand, it is known that only 65% is purchased on credit, therefore, purchases on credit will be: $.4'875,000 ($.10'000,000 x 0.75 x 0.65), distributed in 8 navies, each one of $.609,375.
Simple way to convert the cash conversion cycle into currency units.
There is a simple way, that some Credit Institutions use to convert the Cash Conversion Cycle (CCE) into monetary units, through the result of the product of the Cash Conversion Cycle (CCE) and the Daily Cost of Sale (CVD), as described below:
Cash Conversion Cycle (CCE): 55 days
Total Sale Cost: $.7'500,000
Number of days in the year: 360
Daily Cost of Sales (CVD): $.20,833.33
RESOURCES NEEDED: $. 1,145,833.33
(CCE x CVD)
However, as can be seen, there is a great difference between the results obtained between both methods ($.1'751,736 Vs. $.1'145,833.33).
Important details to take into account
The Cash Conversion Cycle (CCE), as initially indicated, is calculated based on the Average Days of Inventory (DPI), the Average Days of Collection (DPC) and the Average Days of Payment (DPP). The question is: How are each of these ratios calculated? The answer is as follows:
Average Days of Inventory (DPI)
= (Inventories / Total Cost of Sales) x (“n” x 30)
Average Collection Days (DPC)
= (Commercial Accounts Receivable / Total Credit Sales) x (“n” x 30)
Average Payment Days (DPP)
= (Commercial Accounts Payable / Cost of Credit Sales) x (“n” x 30)
Where: “n” = number of months
As it can be seen, in the case of the DPC and DPP neither the Total Sales nor the Total Costs of Sales are used, as some Credit Institutions have erroneously still been doing, but the Total Sales to Credit and the Costs of Sales at Credit, since the ratios measure the collections of credit sales and the payments of credit purchases.
The following example better illustrates what is indicated:
Total Sales: $.1'000,000
Cost of Sales: $. 700,000
Commercial Accounts Receivable: $. 50,000
Commercial Accounts Payable: $ 80,000
Inventories: $. 100,000
Period: 12 months
Credit sales: 50% ($. 500,000)
Credit purchases: 30% ($. 210,000)
Considering total sales and costs:
DPI = ($.100,000 / $. 700,000) x (12 x 30) = 51 days
DPC = ($.50,000 / $.1'000,000) x (12 x 30) = 18 days
DPP = ($.80,000 / $. 700,000) x (12 x 30) = 41 days
CCE = 51 days + 18 days - 41 days = 28 days
The company will need to finance 28 days of its CCE.
However, the total sales and costs are considered, on credit:
DPI = ($.100,000 / $. 700,000) x (12 x 30) = 51 days
DPC = ($.50,000 / $. 500,000) x (12 x 30) = 36 days
DPP = ($.80,000 / $. 210,000) x (12 x 30) = 137 days
CCE = 51 days + 36 days - 137 days = -50 days
The company will not need to finance anything, since its CCE is negative in 50 days, because: DPP> DPI + DPC.
conclusion
Considering in the calculation of the DPC and DPP ratios, Total Sales and Total Sales Costs implies a serious error, since it distorts the CCE result. Likewise, it does not allow measuring the effectiveness of the company's collection policies or compliance with its payment to suppliers. For example: if the credit policy were a maximum of 15 days and we assumed the first method (18 days), we would not realize that collections were actually being carried out on average every 36 days, information that can be decisive when taking the credit decision.
On the other hand, the fact that owners must also make a commitment to their business should never be overlooked. Therefore, it will never be advisable to finance the entire CCE. The participation that the Credit Institutions and the debtor must assume, will depend on the credit policies of each Credit Institution.
