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)

CCC_1.gif

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

CCC_2.gif

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)
CCC_3_a.gif
Dell (DELL)

Cash Cycle =
- 41 days
(4 + 30 – 75)
CCC_4.gif

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.

CCC_5.gif

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!

Related Articles
  1. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  2. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  3. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  6. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  7. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  8. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  9. Mutual Funds & ETFs

    ETF Analysis: Schwab US Broad Market

    Take an in-depth look at the Schwab U.S. Broad Market ETF, an incredibly low-cost fund based on a wide selection of the U.S. equity market.
  10. Professionals

    Tips for Helping Clients Though Market Corrections

    When the stock market sees a steep drop, clients are bound to get anxious. Here are some tips for talking them off the ledge.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  5. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  6. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
RELATED FAQS
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  4. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  5. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
  6. What happens to the shares of stock purchased in a tender offer?

    The shares of stock purchased in a tender offer become the property of the purchaser. From that point forward, the purchaser, ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!