Our friend Jaime is again at a crossroads. According to your Credit Manual, the Cash Conversion Cycle allows you to determine the working capital needs of a business.
However, when analyzing the following year-end information for a business:
Total Sales $.120,000
Total Credit Sales (20%) $. 24,000
Cost of Sales $. 96,000
Cost of Credit Sales (10%) $. 9,600
Trade Accounts Receivable $. 2,000
Inventories $. 8,000
Commercial Accounts Payable $. 1,600
find that:
Average Collection Days (DPC)
= (Trade Accounts Receivable / Total Credit Sales) x 360
= ($.2,000 / $.24,000) x 360
= 30 days
Average Payment Days (DPP)
= (Trade Accounts Payable / Cost of Credit Sales) x 360
= ($.1,600 / $.9,600) x 360
= 60 days
Average Days of Inventory (DPC)
= (Inventories / Total Cost of Sales) x 360
= ($.8,000 / $.96,000) x 360
= 30 days
Cash Conversion Cycle (CCE)
= DPP - DPC - DPI
= 60 days - 30 days - 30 days
= 0 days
Which implies that the business would not need a loan for working capital, since its CCE is equal to ZERO.
However, when reviewing the main items of the Balance Sheet, you observe that there is a difference between Current Assets and Current Liabilities, amounting to $.8,400:
Trade Accounts Receivable $. 2,000
Inventories $. 8,000
Commercial Accounts Payable $. 1,600
Which in his opinion is what should prevail and be financed at the most.
In this regard, Jaime is not far from the truth. The Cash Conversion Cycle can only be applied under two conditions:
All purchases or sales are on credit.
Credit purchases and sales are made in the same percentage.
None of which is fulfilled in the case presented, since:
Sales on credit are 20% of the total sold and
Credit purchases 10% of the total purchased
To better clarify the above, let's look at the following example:
Total Sales $.120,000
Total Credit Sales (20%) $. 24,000
Cost of Sales $. 96,000
Cost of Credit Sales (20%) $. 19,200
Trade Accounts Receivable $. 2,000
Inventories $. 8,000
Commercial Accounts Payable $. 1,600
where:
Average Collection Days (DPC)
= (Trade Accounts Receivable / Total Credit Sales) x 360
= ($.2,000 / $.24,000) x 360
= 30 days
Average Payment Days (DPP)
= (Trade Accounts Payable / Cost of Credit Sales) x 360
= ($.1,600 / $.19,200) x 360
= 30 days
Average Days of Inventory (DPC)
= (Inventories / Total Cost of Sales) x 360
= ($.8,000 / $.96,000) x 360
= 30 days
Cash Conversion Cycle (CCE)
= DPP - DPC - DPI
= 30 days - 30 days - 30 days
= -30 days
Which implies that the business would need a loan for working capital, since its CCE is less than ZERO (-30 days), which converted into monetary terms ($), would be:
$.8,000 = ($. 96,000 / 360) x 30 days
That corresponds to the investment in business inventories, since the commercial accounts receivable are fully financed by suppliers. The difference ($.400) between Commercial Accounts Receivable ($.2,000) and Commercial Accounts Payable ($.1,600) correspond to the gross margin of the sale (20% of $, 2,000).
conclusion
The Cash Conversion Cycle is a tool that allows us to accurately calculate the working capital needs of a business. However, it is necessary to know the percentage of purchases and sales made on credit and that these are made in the same percentage. If not, it is enough to determine the difference between the most relevant items of Current Assets and Current Liabilities and finance a maximum, which could be 100% for old clients and 80% for new clients. The working capital loan amount should never be calculated based on monthly sales.