A timeless piece of advice for investors will always be to stick to the fundamentals. Why do fundamentals matter? Well, in the end, a solid company with strong fundamentals and a management team who is consistent and accountable to investors will likely remain a good long-term company. In other words, your average S&P 500 blue chip firm will likely still be around and their business will, to some degree, grow whether in an up or down market. Additionally, the way the large players of the institutional arena operate attests to the importance of fundamentals. The asset management wings of these heavyweights are not buying tens of millions of shares based on a hunch or whim. They derive model valuations based on fundamentals. In this article, we'll provide an overview of one important fundamental metric: the cash conversion cycle.
What Is the Cash Conversion Cycle?
Speculative trading bubbles will likely come and go, and pure anxiety and sentiment from investors of all sizes will always factor into the market. It is, however, no secret that to pick a solid performer when the market is slow or under attack takes a little more know-how. The cash conversion cycle (a.k.a. net operating cycle), can tell you how cash is moving through a company in terms of duration. This ratio is vital because the cycle represents the number of days a firm's cash remains tied up within the operations of the business
The cash conversion cycle is a derived ratio and is generally not part of ratio comparison sections found in financial portals or websites. You can, however, construct the three ratios that compose the calculation of the cash conversion cycle by taking a little time to look at a firm's inventory, receivables and payables:
|Cash Conversion Cycle (or Net Operating Cycle) = Average Inventory Collection Period + Average Receivables Processing Period – Average Payables Period|
Most financial websites will present these components in a standard ratio comparison, so you need not worry about deriving the ratio independently.
The cash conversion cycle simply indicates the duration of time it takes the firm to convert its activities requiring cash into cash returns. Therefore, a downward trend in this cycle is a positive signal while an upward trend is a negative signal. Why is this so? When the cash conversion cycle shortens, cash becomes free for other uses such as investing in new capital, spending on equipment and infrastructure, as well as preparing for possible share buybacks down the road. On the flip side, when the cash conversion cycle lengthens, cash remains tied up in the firm's core operations, leaving little leeway for other uses of this cash flow. Below is a numerical example of this calculation:
For demonstration purposes, we have steadily held the payables processing period at 72 days. It is clear from the above example that the firm's financial condition, from the perspective of the cash conversion cycle, has improved. Inventory processing and accounts receivable turnover has improved for firm A from year one to year three, implying that the processing period of each has declined.
In taking the time to find the cash conversion cycle, pay attention to the trend of its three general components with special emphasis on the payables processing period. Sometimes shorter processing periods for inventory and/or receivables can be largely offset by increases in the processing period for accounts payables. The processing period for accounts payables will increase if the firm is paying its creditors and suppliers at a slower rate. The main point to remember, however, is that an understanding of each of the three factors in the formula can help pinpoint the trend not only in the cash conversion cycle but also in the individual processing periods themselves, insights that can give both a synopsis of operational efficiency and the justification behind it.