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    Word of the Week: Cash Conversion Cycle

    Rack of tops in a retail setting
    • 26 Jul 2016
    Brian Misamore Author Staff
    tag
    • Business Essentials
    • CORe
    • Leading with Finance

    Have you ever walked into a store and wondered how they paid to fill it with products to sell? The easy answer might be, "with the money they made from the things they sold last month," and that's partially true, but what about for brand new stores? There's probably millions of dollars of inventory on the floor of many large retailers and hundreds of thousands of dollars of inventory on the floor of many small businesses. This working capital must be paid for - but how?

    Many companies will take on debt to finance their inventories. Suppliers, eager to get business, will often offer credit terms, and each company decides how and when to take advantage of these through maintaining an Accounts Payable balance. This gap between paying for the products and receiving the money for selling them is called the cash conversion cycle.

    Cash Conversion Cycle: the amount of time that passes between when a company spends money to buy an item and when they receive the money for selling it.

    To calculate the cash conversion cycle, take the average number of days it takes to sell inventory, plus the average number of days it takes to receive payment for that sold inventory, minus the average number of days before paying for received inventory. In terms of accounting ratios, this is:

    Cash Conversion Cycle = Days Inventory + Days Receivables – Days Payables

    A typical company receives inventory, pays later for that inventory, sells the inventory, then receives payment for it.

    The implications of the cash conversion cycle are powerful. To illustrate with an example, imagine a company that buys t-shirts for $10 and sells them for $15 – a very simple business. If they have a cash conversion cycle of seven days, this implies that for one week they have lost the $10 needed to purchase each t-shirt but have not yet received the $15 for selling them. Where do they get money to buy more t-shirts and maintain their inventory?

    Financing this time through debt can impose a considerable cost on the company, especially for companies with very long cash conversion cycles. The longer the cash conversion cycle, the higher the interest paid on the debt.

    Imagine a company that has a negative cash conversion cycle, like Amazon. By selling inventory quickly (low Days Inventory), receiving payment immediately for most sales (low Days Receivables) and putting off payment to suppliers for as long as possible (high Days Payables), their Cash Conversion Cycle is negative.

    That means that Amazon actually gets paid for items they sell before they pay for them themselves. So, instead of paying interest to buy items for sale, they are receiving interest by holding cash in their bank account (or investing it in growing their company). This produces a powerful engine for cash generation and growth.

    To learn more about the cash conversion cycles of Amazon and other organizations, take a look at this article from Forbes.

    Interested in learning more about accounting as well as analytics and economics? Gain confidence in the fundamentals of business with CORe.

    Learn More About CORe

    About the Author

    Brian is a former member of Harvard Business School Online's Course Delivery Team and was the lead content developer for Leading with Finance and Management Essentials. He is a veteran of the United States submarine force and has a background in the insurance industry. He holds an MBA from McGill University in Montreal.
     
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    Our platform features short, highly produced videos of HBS faculty and guest business experts, interactive graphs and exercises, cold calls to keep you engaged, and opportunities to contribute to a vibrant online community.

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    Our easy online application is free, and no special documentation is required. All participants must be at least 18 years of age, proficient in English, and committed to learning and engaging with fellow participants throughout the program.

    Updates to your application and enrollment status will be shown on your account page. We confirm enrollment eligibility within one week of your application for CORe and three weeks for CLIMB. HBS Online does not use race, gender, ethnicity, or any protected class as criteria for admissions for any HBS Online program.

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