Second-year student Rohan Rajiv is blogging once a week about important lessons he is learning at Kellogg. Read more of his posts here.
Let’s imagine a company we’ll call Nile, Inc.
Nile is a vegetable retailer who has the following metrics:
- Cost of Goods Sold (COGS) = $365
- Average Inventory = $10 (In general, it has low levels of inventory.)
- Sales = $1095
- Accounts Receivable = $30
- Accounts Payable = $30
Based on these metrics, we can do the following calculations:
- Inventory Turnover = COGS/Average Inventory = 36.5
Nile, Inc., turns over its inventory 36.5 times a year. That’s a good sign; more turns means a more efficient inventory buying process.
- DSI or Day Sales Inventory = (1/Inventory Turnover) * 365 = 10 days
This means it takes Nile, Inc., 10 days to convert its stockpile of inventory into cash. If Nile turned its inventory slower, it would take longer. Since Nile is a vegetable retailer, however, we can imagine that it requires a quick turn of fresh produce.
- Receivables Collection Period = Accounts Receivable / (Sales/365) = 10 days
This means it takes Nile 10 days to collect its receivables. This period is common in businesses that work with consumers, as credit card money comes within five to 10 days.
- Payable Period = Accounts Payable / (Sales/365) = 10 days
Nile takes 10 days to pay its suppliers – a short payable period for most businesses – because of its size. As Nile grows, it is can extract longer payable periods (e.g. 100 days).
Now, we can draw out what this process looks like:
Nile takes 20 days to convert inventory to cash – 10 days to convert it from inventory to a sale, and 10 more days to convert the sale to cash. However, since it takes 10 days to pay suppliers, we can now reduce the 20-day number to 10 days.
These 10 days are Nile’s cash conversion cycle (CCC). The cash conversion cycle is an important idea since this means that Nile requires 10 days’ worth of working capital (Current Assets – Current Liabilities on the balance sheet) to keep its business solvent. Since, at any given point, Nile will require enough cash to support 10 days of operations, if it doesn’t have the cash itself, it will always need access to a revolving line of credit that can make sure the business runs. Reducing the CCC is an attractive prospect for most small businesses, as it means less dependence on external capital. It also reduces the working capital requirements of the firm.
Amazon is an example of a firm that does an outstanding job with working capital management.
As you can see, Amazon’s CCC is actually negative. This means that Amazon receives cash very quickly and turns over its inventory quickly, but takes much longer to pay its suppliers. The business is practically throwing off cash. Negative CCCs work well for growing businesses, but when businesses stop growing, these cycles can be painful since it means you have to pay your suppliers greater amounts than you make.
A big thanks to Professor Efraim Benmelech and my Financial Decisions course for deepening my understanding of working capital and CCCs!
Rohan Rajiv is a second-year student in Kellogg’s Full-Time Two-Year Program. Prior to Kellogg he worked as a consultant serving clients across 14 countries in Europe, Asia, Australia and South America. He interned at LinkedIn in Business Operations and will be heading back to LinkedIn full-time after he graduates in June 2016. He blogs a learning every day, including his MBA Learnings series, on www.ALearningaDay.com.