Relationship Of Cash Conversion Cycle With Working Capital Finance Essay
Cash flow is the all businesses life blood and is the primary indicator of business health. It is generally acknowledged for most small and medium-sized enterprises (SMEs) as the single most pressing concern, although even finance directors in the organizations emphasize the importance of cash, and cash flow modeling is the most important fundamental part of any private equity buy-out. In a credit crunch environment, which access to liquidity is highly restricted, cash management becomes critical skill for a organization to survive in the market.
In a more simple form, cash flow is the in and out of money movement in a business. It is not really showed the organization profit and loss, although business trading had clearly has an obvious effect on cash flow. The effect of cash flow is immediate, real and, if miss managed it nicely, it will be totally unforgivable. So that, cash needs to be monitored, protected, controlled well and put to work completely.
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Next, to control the organization day to day business activities, cash is important to meet the need from time to time, to catch business opportunities and to repay for the loan or liabilities. Therefore, organization must have a well cash-management-approach to hold the total amount needed of cash within a given time period.
Cash budget is a necessary 'homework' that each company must to do so. It is a important step to measure the company's cash inflows and outflows during a period of time. Basically, organizations will prepare the cash budget for the next six months of the year, and prepare a more detailed cash budget for monthly, weekly or daily basic according to need of each of the company in different situation, firm size, and business doing.
Furthermore, to assessing the liquidity of firms, a useful way is using the cash conversion cycle (CCC) (Moss and Stine, 1993). Cash Conversion Cycle (CCC) is a metric that expresses the length of time, in days, that it takes for a company to convertÂ resource inputs into cash flows.Â (Investopedia, 2010). On the other hand, the CCC is a dynamic measure of ongoing liquidity management, since it combines both balance sheet and income statement data to create a measure with a time dimension (Jose et al., 1996).
Besides that, working capital shows the amount of cash tied up in the business trading assets. It is usually calculated as:
Business Trading Assets = stock (including finished goods, work in progress and raw materials) + trade debtors - trade creditors.
Some businesses have working capital tied up in receivables and inventory, but not included all of them.
Thus, if a organization is in the trading profitably, each times of the cash conversion cycle turns around; a little bit more money are putting back into the business again than flows out of the organization, but it is not a necessarily to do it so. If you don't carefully monitor your cash flow clearly and take corrective action when it is necessary, the business may end up in troubles and problems when something that you are not predicted happened suddenly. If cash flow is carefully monitored in the organization, you should be able to easily forecast accurately for the number of cash will be available on hand at any time being, and plan your business for future activities to ensure there is always enough cash to meet up any coming payments.
In textbooks related to finance, the Cash Conversion Cycle (CCC) is mentioned in the context of working capital management (Keown et al., 2003; and Bodie and Merton, 2000). The Cash Conversion Cycle (CCC) is used as a comprehensive measure of working capital as it shows the time lag between expenditure for the purchases of raw materials and the collection of sales of finished goods (Padachi, 2006, p. 49).
In day-to-day effective management of a firm's of their short-term assets and liabilities plays a very important role in the success or failure of the firm. Firms with glowing long term prospects and healthy bottom lines do not remain solvent without good liquidity management (Jose et al., 1996, p.33).
An expression of the amount of cash you have tied up in unpaid invoices from customers. Most businesses offer credit in order to help customers manage their own cash flow cycle (more on that shortly) and that uncollected cash is a cost to the business. DSO = 365 x accounts receivable balance / annual sales.
This expression tells you how you're doing with suppliers. The aim here is a higher number, if your suppliers are effectively lending you money to buy their services, that's cash you can use elsewhere in the business. DPO = 365 x accounts payable balance/annual cost of goods sold.
This is tells you how much cash you have tied up in stock and raw materials. Like DSO, a lower number is better. DI = 365 x inventory balance/annual sales.
From the figure, we may know that CCC can be positive or negative result. A positive result indicates the number of days a company must borrow or tie up capital while awaiting payment from a customer. A negative result indicates the number of days a company has received cash from sales before it must pay its suppliers (Hutchison et al., 2007, p.42).
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If possible, organization would like to have a negative result of CCC. It is because the lesser the CCC shows more efficient of the organization managing its cash. So, smart management of cash flow cycle, including tighter business processes and better credit management, is essential.
As we know, in small and medium sized enterprises, credit and cash management includes advice on maximizing cash inflows, managing or reduce the cash outflows, extending the credit payment period and cash flow forecasting in the future. It is not necessary to be complex or complicated, but it is a good act for financial managers in smaller businesses industry as their basic guide for managing the cash in the company.
A firm is required to maintain a balance between liquidity and profitability while conducting its day to day operations (Kesseven, 2006). To measure a company's liquidity and profitability, we may use those liquidity and profitability ratios. As we know, cash is the most liquid asset than other assets that can directly lead your business to continue or to shut down.
Cash is not given free and it is not the passive, inevitable outcome of the business endeavors. It does not appear willingly in your bank account. Rather it had to be tracked, or earned. Organizations need to control the process of trading and there is always some scopes for improvement to be done. Cash management is as much an integral part of your business cycle as, for example, making and shipping widgets or preparing and providing detailed consultancy services.
Besides, organizations need a good and clear liquidity management. It is a management process of current assets and current liabilities which plays a significant role in deciding the successful organizations. The organizations also can use liquidity ratios to calculate their liquidity's status. There are 3 ratios for understanding each organization's liquidity, which are: current ratio, acid-test ratio and cash flow ratio. All the three ratios can be calculated to measure the relationship of the current assets and liabilities. Jose et al. (1996) pointed out this fact saying "firms with glowing long term prospects and healthy bottom lines do not remain solvent without good liquidity management". It means a company with good liquidity management will be able to continue successfully and smoothly as going concern.
Any changes in the cash cycle will directly affect the amount of working capital requirements in the company. In general, the longer the inventory turnover and the receivables turnover, the shorter the accounts payable turnover needed and the greater the amount of working capital in the organization. On the contrary, the shorter the inventory turnover and receivables turnover, the longer the accounts payable turnover and smaller the amount of working capital of the organization showed. In addition, the amount of operating cash flow is also subject to the risks, the revenue requirements, cost constraints and other factors that influences.
Working capital that included in the operating working capital should be a fully cycle in the industry. The cycle length is related to both of the cost of capital and the use of efficiency of the capital. Assume that the microscopic production of personal computer companies, predicted market demand for 100 units. The following steps are to determine their possible future cash flows, and display their decision of the production on the company's liquidity position:
The company ordered the production of 100 units of computers and components. It is required for the computer industry to start with the purchase of raw materials and spare parts used on credit. So that it will only occur in accounts payable of the transaction, there is no immediate impact on cash flow.
Employ a certain number of workers, wages had not been fully paid, and thus part of the wages payable occurs. When the product is completed, assembling components into storage.
Computer product sales sold through credit, accounts receivable have occurred, there is no immediate cash flow in the period.
At some point in the production process, before the recovery of accounts receivable, accounts payable and the company must pay the wages payable that had occurred "net cash outflow." The cash outflow can be obtained from bank loan financing.
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When the company collects the accounts receivable from the customers, the liquidity of the cash flow cycle (cash flow cycle) have been completed by all the action. At this time the company had the ability to repay loans that make before. The purpose of this loan helps carry out production and operating working capital. The computer companies marketing activities, buying of components process and the artificial process convert into Cash Conversion Cycle.
Inventory conversion period refer to raw materials or components to manufacture the product, and the time required for products sold.
Inventory turnover times more, on behalf of the company's ability to sell goods and operating performance of the better efficiency, it should not be too long during the stock conversion.
Receivables conversion period means the time required for accounts receivable to recover the cash. It is also known as sales account the number of days (days sales outstanding, DSO).
Accounts receivable $ 1.5 million assuming $ 10 million sales, the DSO is calculated as:
Accounts receivable turnover rate was higher that the speed and efficiency of enterprise billing the better. DSO was 54 days, its significance for the occurrence of the accounts receivable sales into cash, be 54 days long. Inventory and accounts receivable during the
conversion period conversion collectively referred to as business cycles.
Deferred accounts payable during the period means the purchase of materials or hire from the artificial to the deferred payment of the price and the average wage by the number of days. Generally, company paid for purchase of materials and wages of the deferred period, usually 30 days.
Since its length is equal to purchase (production requirements) of raw materials and labor from the date of payment of cash, to sell back the date of the purchase price of the number of days elapsed. It can measure the company's cash frozen in liquid assets on the length of time.
4.1 Cash cycle can be calculated in the following formula:
Stock conversion during the conversion period + accounts receivable - accounts payable period = the cash deferred cycle compared with the number of days, said:
72 days +54 days -30 days = 96 days
From another point of view, was:
Deferred cash collection days - the number of days cash expenses = net deferred the number of days
(72 days +54 days) - (30 days) = 96 days
It is because of the length of the working relationship of the length of time, the freezing of funds and affect of the cost of capital and the use of effectiveness. Financial managers should examine possible ways to shorten the cycle to improve the efficiency of funds and operating income.
Therefore, reduce the inventory turnover and accounts receivable turnover affected accounts payable payment period extended to shorten the cash cycle is the basic way. Enterprises according to their actual situation, compressed collection process, optimize the process such as the use of cash loans to pay the floating margin, payment of accounts, extension payment, the establishment of zero-balance accounts, remote payment and so on, as far as possible within a reasonable extend the loan to pay time and speed up the turnover of cash flow, the corresponding effect of increased use of cash, thus increasing the company's earnings.
From the example, we know that the quicker you can collect cash, the faster you can spend it in pursuit for further profit or to meet up cash outflows such as wages and debt payments. There are some elements which will affect the CCC.
5.1 Customer purchase decision and ordering
Without customers, there will be no cash inflow to manage. So, it is important to make sure that your business is advertised effectively and make it easy for the customers to place an order on your products. Use accessible, up-to-date catalogues, displays, price lists, e-shop, proposals, slogan or quotations to keep your customer informed. Provide ways to bypass the postal service. Accept orders over the Internet, by telephone, or via fax. Make the ordering process quick, precise and easy.
5.2 Fulfillment, shipping and handling
The proper and quality fulfillment of your customers' orders is a most important aspect. Terms and conditions apply as much to you as they do to your customers. The cash conversion period is increased significantly if your business is unable to supply to specification or within an agreed time period, whether that's because you have some problems with inventory or production processes or because you lack the skilled resources to provide the services requested will make the organization images in customer mind reduce.
5.3 The collection period
Customers are often given 30 days to pay for from the date of the invoice in. The time allowed is fully under your control and you can specify a shorter period if you need to. Particularly, if the customer is a consumer rather than a business that will be managing its own cash flow cycle. Organization must judge the benefit to your cash flow against the possible cost of deterring some customers.
5.4 Forecasting cash inflows
Forecasting your sales is an important key to project your cash receipts. Any forecast will include some uncertainty and will be subject to many variables: the economy, competitive influences, demand and supply and etc. It will also include other sources of revenue such as investment income, but sales are the primary source. If the business only accepts cash sales, then your projected cash receipts will equal the amount of sales predicted in the sales forecast.
As outlined at the outset, cash flow is equal to all businesses life bloods, and it becomes even more important when the world going through an economic downturn. Cash flow has to be managed well. Cash management is as much an integral part of the business cycle as any other part of the process. The effect of cash is immediate, real and if miss-managed or not managed it well, it will be totally unforgivable. It can be your ruination, but with care will be your servant and reward.
The cash flow forecast, budget can projects your business cash inflows and outflows over a certain period of time. It can help you see potential cash flow gaps to any time periods when cash outflows exceed cash inflows when combined with the organization cash reserves, it allow you to take steps to avoid expensive, uncontrolled overdrafts or failure to meet crucial payments. These steps might include lowering the organization investment in accounts receivable or inventory, increasing or advancing receipts, and looking to outside sources of cash, such as a short-term loan to fill the negative cash flow gaps.
Good cash management has a double benefit for the organization. It can help you to avoid the debilitating downside of cash crises and it can grant you a commercial edge in all your organization transactions. For example, as organization is able to aggressively manage their inventory which will require less working capital and it is be able to extend to a more competitive credit terms than their competitors.
At last, cash management will give the business just as much of an edge in your transactions and an obviously improvement in the organization manufacturing process or service delivery for control and prosper of the organization.
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