The cash conversion cycle (or "cash cycle") is one of the best early-warning systems available to you. It has an impressive history of sounding the alarm bell ahead of deteriorating company fundamentals. At the Investopedia Advisor, we include the cash cycle in our red flag checklist. This is critical because one or two disastrous picks can ruin an otherwise smart portfolio. Conversely, if you can avoid losses altogether, you are bound to outperform (aside: this is probably the most under-appreciated investment strategy: trying to avoid losses). We cannot predict the future, but we can tilt the odds in our favor by keeping our eyes peeled for lurking "bear traps." Let's take a quick look at one of our best allies in this effort to stay out of trouble.

The cash cycle is days inventory outstanding (DIO) plus days sales outstanding (DSO) minus days payable outstanding (DPO). Here is a graphical version:

Cash Cycle
Days Inventory (DIO) + Sales (DSO) –Payables (DPO)



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Another name for the cash cycle is working capital days, because it is the number of average days that must be funded with working capital. Let's walk through the graphic. Once a company puts raw materials into production, it has started to deploy working capital to build inventory. After it finishes building inventory, it starts selling and shipping product. Along with the product, the company sends an invoice and then waits to get paid. Remember, while the company is building and shipping product, it is using cash rather than collecting cash and that's why it needs working capital. Days sales outstanding (DSO) is the average number of days the company "waits" before it collects cash from customers. In this way, inventory and receivables chew up working capital. Thankfully, the company does not pay its own suppliers immediately but rather sits on those invoices for a bit. Days payable outstanding (DPO) is the average number of days before the company pays its own bills. In this way, DPO saves the company's cash-if only temporarily-and therefore offsets the impact of DIO and DSO.

You can now see how the cash cycle is a measure of working capital. A longer cash cycle signifies a greater need for working capital. Why is a shorter cash cycle better? Because capital costs money! Take a look at Avery Dennison (AVY). Avery is a truly global consumer products company best known for adhesives and its popular Avery printer labels, but they are also an emerging player in the growing market for radio frequency identification (RFID) tags. Pressure-sensitive labels are an ideal place to put RFID chips. For many years, Avery has focused on economic value added (EVA) as a corporate performance measure. EVA has a really simple goal: use capital sparingly, or at least wisely. EVA is perfectly in harmony with the cash cycle measure. A company trying to maximize EVA will, by definition, also be trying to reduce their cash conversion cycle. Here is Avery's cash cycle:
Avery Dennison's (AVY) Cash Cycle
Trailing Twelve Months (TTM) ended 7/2/05


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Avery holds inventory for an average of 42 days and takes 57 days to collect cash from its customers. They also take 55 days to pay their own suppliers, so the cash cycle is 44 days. This is an improvement over the prior year's 48 days. Before we sneeze this off as "only four days," consider that this improvement saves Avery about $2 million dollars a year! With a cost of goods (COGS) of about $3.85 billion, if we assume a financing cost of 5%, then each single day of working capital costs Avery Dennison about $500,000 ($3.85 billion/365 days x 5% financing cost).



So, like many metrics, the way to use the cash cycle is not in a vacuum, but in relative terms. First, how is the company doing against itself; i.e., what is the trend? Second, how is the company doing compared to its peers? There is no magical benchmark because industry dynamics vary. Medical device and supply companies tend toward longer cycles and software companies, for example, have no inventory and therefore shorter cycles.

Each of the elements of the cash cycle contains information. Days payable (DPO) will often tell you about the company's market power with vendors. Days inventory (DIO) is important but can be tricky. Generally, an abrupt increase here should cause you to ask, what's happening? Sometimes the reason is good (e.g., the company is stocking up ahead of demand) but often unsold inventory is just piling up and a bad surprise might be around the bend. Days sales (DSO) might be the most important. Rapid deterioration here (that is, an abrupt increase in DSO) is often a red flag – customers are not paying as quickly or the company is using "favorable terms" in order to push product that isn't otherwise in demand. The road is littered with stocks that first showed a DSO deterioration before the bad news became "more public."

Dell Computer (DELL) redefined the possibilities of a supply chain under the direct-to-consumer model. You can see simply magical benefits of their world class supply chain in the cash cycle metric. Here we compare Dell's cash cycle to Gateway's (GTW):



Gateway (GTW)

Cash Cycle =
- 7 days
(23 + 33 – 63)
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Dell (DELL)

Cash Cycle =
- 41 days
(4 + 30 – 75)
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Now, Gateway has managed to tweak out an impressive cash cycle of negative seven days. Despite the fact I have been warning readers to stay out of Gateway for years, it has not been due to a flawed cash cycle, it is actually quite impressive, but rather for strategic reasons which I won't get into here.

So, Gateway has managed to produce a nice cash cycle. Now look at Dell. They have an astonishing cash cycle of negative 41 days. (EBay (EBAY) is the only company I know of with a better cash cycle). Dell has reduced its inventory to an average of four days, a feat that was unthinkable only a decade ago. And through utter market domination, they delay their own payables to suppliers to a full 75 days (something like, "we will pay you when we want to, you are so lucky to do business with us").




How much of an advantage is this? Dell could have its margins squeezed to zero and still generate cash! That's because they get to hold onto customers' cash for an average of 41 days. Let's assume they can park this cash for 5% instead of putting into working capital, like most of the rest of the world. By my estimation, if Dell's net margins were zero-yes, that means reported profits or zero-they would still generate about $240 million dollars in positive cashflow ($42.975 billion in COGS/365 days x 5% return on cash).

For our final look, we compare a few discounted retailers in this sector, the cash cycle has done an admirable job of anticipating good and poor performance. Retailers with low and improving cash cycles have generally out-performed over the long term. At the other end, retailers with high averages and/or deteriorating cash cycles have often under-performed; e.g., Cost Plus (CPWM) shows the worst cash cycle at 120 days and its stock has languished over the long term.



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Of course, the cash cycle is only one metric-just a piece of the overall puzzle. In most situations, it will contribute to a larger case "for" or "against" a particular stock idea. But if it helps you avoid even a single bad investment, you will be glad you reached for it!



Filed Under:
Tickers in this Article: AVY, DELL, GTW, CPWM, WMT, TGT, COST, TJX, DG, NDN, FRED

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