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Close to 50% of the typical industrial and retail firm’s assets are held as working capital. Many newly minted college graduates work in positions that focus on working capital management, particularly in small businesses in which most new jobs are created in today’s economy.
To prepare for this Discussion: Shared Practice, select two of the following components of working capital management: the cash conversion cycle, the cash budget, inventory management, and credit policies. Think about scenarios in which your selected topics were important for informing decision making. Be sure to review the video links above and conduct additional research using academically reviewed materials, and your professional experience on working capital concepts to help develop your scenarios. Support your discussion with appropriate examples including numerical examples as necessary.
The cash conversion cycle:
The cash conversion cycle is a cash flow calculation that aims to measure the time it takes a company to convert its investment in inventory and another resource into cash. In other words, the cash conversion cycle calculation measures how long cash is tied up in inventory before the inventory is sold, and cash is collected from customers.
The cash cycle has three distinct parts.
The first part of the cycle represents the current inventory level and how long it will take the company to sell this inventory. This stage is calculated by using the day’s inventory outstanding calculation.
The second stage of the cash cycle represents the current sales and the amount of time it takes to collect the cash from these sales. This is calculated by using the day’s sales outstanding calculation.
The third stage represents the current outstanding payables. In other words, this represents how much a company owes its current vendors for inventory and goods purchases, and when the company will have to pay off its vendors. This is calculated by using the day’s payables outstanding calculation.
Formula: Cash conversion cycle = Days inventory outstanding + Days sales outstanding – Days payable outstanding.
Days inventory outstanding = Inventory/ cost of sales
Days sales outstanding = Accounts Receivables / Net credit sales
Days payable outstanding = Accounts Payable / cost of sales
Example: Mr Amit is a retailer, sells machinery components. Amit buys its inventory from vendor Company – A and pays its accounts within 10 days in order to get a purchase discount. Amit has a reasonably high inventory turnover ratio for his industry and can collect accounts receivables from his customer within 30 days on average.
Days inventory outstanding : 15 days
Days sales outstanding : 2 days
Days payable outstanding : 12 days
Cash conversion cycle = 15 days + 2 days – 12 days = 5 days,
So, Amit cash conversion cycle is 5 days. This means it takes Amit 5 days from paying for his inventory to receive the cash from its sale(Ankit, 2016).
Inventory constitute the major important component of current assets, so inventory management is very much crucial for the management. Excess investment in inventory would lead to reducing in profitability as more fund would be blocked into inventory and if low level of inventory of is maintained there would be a shortage of inventory resulting in stoppage of production due to lack of inventory.
Effective inventory management is done by various inventory management techniques like Economic order quantity, different level of stocks like safety stock, reorder level, reorder quantity, the maximum level of inventory, the minimum level of inventory, ABC technique etc
One of the analytical technique of inventory management is Just in time in which no stock is maintained, and inventory is ordered when production goes on, in this type of situation management of inventory is very much essential to avoid the situation of shortage of inventory and stop of production.
Types of inventories:
- Raw material inventory as input to manufacturing system.
- Bought-out-parts inventory which directly go to the assembly of product as it is.
- Work-in-process inventory
- Finished goods inventory for supporting the distribution to the customers.
Inventory Management plan is so important for example if we did not have inventories, there will be shortages, production delays, and project delays.
Example: if the company has taken $ 100,000 as loan to maintain stock at fullest level. Instead of that, if the company reduce the stock by 10 percent that could reduce the loan to $ 99,000, which at the same time reduces the interest rate also. On the other end maintenance cost on inventory also reduces
Cash Budget Discussion
Working capital is used as a common measure of an organization’s liquidity since it includes cash and inventory. It is divided into two parts which are positive and negative working capital. Positive working capital shows that an organization is capable of paying-off all its short term liabilities while negative working capital shows the contrary (Mathuva, 2015). Nowadays, it is not easy to maintain working capital because of the high expenses that organizations incur. This is why components of working capital such as the cash conversion cycle and inventory management have become important tools for decision making.
The cash conversion cycle helps a company to measure the duration it takes to convert its inventory into cash (Nobanee, Abdullatif & AlHajjar, 2011). This component of working capital management measures the duration that cash is tied up in inventory before the inventory is turned into cash. For example, a company can use the cash conversion cycle to determine the current sales and the time that is taken to collect money from these sales. The cash conversion cycle also helps a company to make decisions concerning when to pay off its debts because it provides information on how much a company owns its vendors. The formula used for measuring the cash conversion cycle is:
Cash Conversion Cycle = Inventory Outstanding (DIO) + Sales Outstanding (DSO) + Payable Outstanding (DPO)
Inventory management helps a company to determine the stock of its items and resources. It plays a vital role when a company wants to make decisions on which policies should be set to help in monitoring the levels of inventory (Mathuva, 2015). For example, a company can use this component of working capital management to know when it should replenish its stock as well as how large its orders should be.
The cash conversion cycle
The cash conversion cycle is one of the ways to measure the effectiveness of management and it measures how fast a company can convert cash on hand. In general, the low the cash conversion cycle is, the better for the company. The CCC does this by following the cash as it is first converted into inventory and accountable payable (AP), through sales and accounts receivable (AR), and then back into cash (Jim Mueller, 2017).
The formula of cash conversion cycle is: CCC=DIO + DSO – DPO.
DIO stands for days inventory outstanding, means how long it will take the company to sell its inventory;
DSO stands for days sales outstanding, means the amount of time it takes to collect cash from these sales;
DPO stands for days payable outstanding, means the amount of time it takes for the company to pay off its suppliers.
For example, a company reported a $2,000 beginning inventory and $6,000 ending inventory for the fiscal year ended 2018 with $50,000 cost of goods sold. The DIO for this company is:
DIO= ($2,000+$6,000) *365/2/$50,000=29.2
This company reported a $3,000 beginning accounts receivable and $8,000 ending accounts receivable for the fiscal year ended in 2018 with credit sales of $150,000. The DSO for this company is:
DSO = ($3,000+$8,000) *365/2/$150,000 = 13.38
This company reported a $1,500 beginning accounts payable and $3,000 ending accounts payable for the fiscal year ended 2018 with $ 50,000 cost of goods sold. The DSO for this company is:
DPO = ($1,500+$3,000)*365/2/$50,000 = 16.425
So, this company CCC is:
CCC = DIO+DSO-DPO=29.2+13.38-16.425=26.155
Cash conversion cycle is an important metric for a business to determine the efficiency at which company is able to covert its inventory into sales and then into cash; a business loves to see lower cash conversion cycle since it is conducive to healthy working capital levels, cash flows, liquidity and profitability of a firm (Ankit Jaiswal, 2016).