Developing a Basic Financial Model – Part V: More on the Cash Conversion Cycle

In continuing in our series of fundamental concepts of financial modeling, I would like to spend a bit more drilling down into some detail on the cash conversion cycle, or cash cycle ("CC") prior to heading on to long-term assets and long-term liabilities. This relatively straightforward concept can provide some insights into determining whether or not a business has become more efficient or is headed towards insolvency. This has impact on a financial modeler because historical CC values should not differ substantially from the forecast unless the financial analyst has specific, relevant information to suggest that there will be a shift in the operations of a business in the future.

As a quick refresher, the CC is equal to days receivables outstanding PLUS days inventory outstanding MINUS days payables outstanding, or DSO + DIO - DPO. This determines how quickly a company receives cash when it sells a product from inventory. Depending on the industry, the cycle can be very quick or very slow. For example, assume that you are a manufacturer of large, custom made home furniture, like armoires. A typical process would be a customer placing an order on day one, and at that time, you need to begin the process of making the furniture.

The first step would be to call a supplier of raw materials and begin making the product. Assume that it takes 60 days from the time of the order from a customer to complete the work. Further assume that your supplier, while a close relationship, only extends terms to 30 days. This means that you have to finance the payment to the supplier, or the payable, until you receive cash from the customer. If you do not offer terms and 100% of the balance is due at the time of completion, then you are only financing for 30 days. If you operation is on a commercial scale in that you manufacture custom furniture for office spaces or industrial facilities, you would probably offer some sort of terms to your customers. This will increase the time you need to finance the payables. If it is 30 days, then the CC = 30 + 60 - 30, or 60 days until you receive the cash. This means that working capital is "tied up" for 60 days, or said another way, you are financing the time period of 60 days until you receive the cash for your work.

In the prior example, a company might have enough cash on hand to finance the 60-day process, but if it doesn't, another form of financing is needed, like a bank line or other external financing form. This is not free and the interest charged over the process of the borrowing constitutes part of the total cost to a company for running its business. This is not an insignificant component and needs to be considered when modeling the business operations.

The CC is more often used for manufacturing entities, or what I would call old line businesses - the bricks and mortar operations. What if you have a service business? In this case, there is likely to be little to no inventory, so that component is no longer part of the equation, leaving DSO and DPO. In many instances, say a consulting business, you bill be the hour and provide an invoice on a monthly basis. There are likely to be terms, so you would have a DSO number that is greater than zero. As for DPO, there may not be much involved in that category. To keep it very simple, if there is a consulting firm with four employees working out of a small office, the major expenses you will have are the salaries of those employees. While there may be some payables for things like office equipment or supplies, those are not related to providing a service in the similar fashion as buying materials to make saleable inventory products for a manufacturing business. Therefore, when analyzing a services business, the DSO may be the only component of the CC. In this scenario, there is little value added in understanding the CC.

In summary, I think that understanding the CC for entities who need to invest in inventory and who are more likely to be concerned with managing payables and receivables is important. You have to understand how cash it tied up and the costs associated with managing working capital. While this concept is more relevant to some companies more than others, understanding the process from delivery of goods to receiving cash is a fundamental building block of financial modeling.