Examining the cash conversion cycle for a company is an interesting method to evaluate the efficiency of a company's operations. What it measures is how quickly a company converts its products into cash, and luckily it is easy to calculate from publicly available information. The shorter this metric, the better for a company.

The cash conversion cycle is calculated by adding together days inventory outstanding and days sales outstanding and then subtracting days payable outstanding. Here is how to calculate these three measures:

1. Days Inventory Outstanding - Inventories divided by cost of sales multiplied by 365. This measures how quickly a company converts its inventory into sales. The lower the number of days the better for a company's operations.

2. Days Sales Outstanding - Accounts receivable divided by total credit sales multiplied by 365. This measures how quickly a company collects from its customers. The lower the number of days the better for a company's operations.

3. Days Payables Outstanding - Accounts payable divided by cost of sales multiplied by 365. This measures how quickly a company pays its bills. In contrast to the first two measures, a company wants its days payable outstanding to be as high as possible.

Some companies have business models that result in a negative cash conversion cycle, which essentially means that a company gets paid for its products before it pays its suppliers. This is an ideal situation. (For more, read Using The Cash Conversion Cycle.)

Cash Converting All Stars
Two companies that have incorporated a negative cash conversion cycle into their business models are Amazon (Nasdaq:AMZN) and Dell Computer (Nasdaq:DELL). Here are how the calculations break down.

 - Dell Amazon Days Inventory Outstanding Inventories \$1,180 \$1,200 Costs of Sales \$49,462 \$11,482 Days 365 365 Days Inventory Outstanding 8.71 38.15 Days Sales Outstanding Accounts Receivable \$7,693 \$852 Total Sales \$61,133 \$14,835 Days 365 365 Days Sales Outstanding 45.9 20.96 Days Payables Outstanding Accounts Payable \$11,591 \$3,714 Cost of Sales \$49,462 \$11,482 Days 365 365 Days Payables Outstanding 85.5 118.06 - - - Cash Conversion Cycle (30.90) (58.95) All numbers in millions, using annual data in most recently completed fiscal year: February 2008 for Dell, and December 2007 for Amazon

Let's take Amazon first. What the numbers below mean is that Amazon takes 59 days to get its products ready for sale and to collect the money for it. It then takes 118 days to pay its supplier. The result is a negative 59 days for the cash conversion cycle. Dell is also very efficient, at negative 31 days.

Homebuilders and Cash Conversion
Not all companies are as efficient as these Amazon and Dell. The homebuilding industry is notorious for having a lengthy cash conversion cycle. This is because a company must buy raw land, get the land permitted for development by the municipal or state authorities, build infrastructure such as water, sewer and roads, and then build a house. During this entire process the homebuilder is laying out cash. After it finally finds a buyer for the house and gets a signed contract, it still has to wait at least a month for mortgage approval and the closing.

 - Hovnanian Toll Brothers KB Homes Days Inventory Outstanding Inventories \$3,518 \$5,572 \$3,312 Costs of Sales \$4,567 \$4,125 \$6,826 Days 365 365 365 Days Inventory Outstanding 281.17 493.05 177.11 Days Sales Outstanding Accounts Receivable \$304 \$135 \$295 Total Sales \$4,798 \$4,646 \$6,416 Days 365 365 365 Days Sales Outstanding 23.1 10.7 16.8 Days Payables Outstanding Accounts Payable \$578 \$481 \$1,675 Cost of Sales \$4,567 \$4,125 \$6,826 Days 365 365 365 Days Payables Outstanding 46.3 42.6 89.6 - - - - Cash Conversion Cycle 258.04 461.08 104.34 All numbers in millions using annual data in most recently completed fiscal year: October 2007 for Toll Bros. and Hovnanian. November 2007 for KB Homes

The cash conversion cycle for KB Homes (NYSE:KBH) is the lowest at 104 days, but it should be noted that KB Homes is the only one of the three with a negative gross margin (sales less cost of sales, as a percentage of sales). Since its days inventory outstanding is so low, that may indicate that it was selling inventory at a low price to generate sales. Toll Brothers (NYSE:TOL) is the highest at 461 days. This may indicate the opposite of KB Homes, that Toll Brothers elected to hold onto its inventory rather than dump it at fire-sale prices. Hovnanian (NYSE:HOV) seems to be in the middle of the two with a cash conversion cycle of 258 days.

Bottom Line
The cash conversion cycle is an important financial metric to determine the efficiency at which a company converts its inventory into sales and then into cash. It might be a way to help investors convert stock picks into cash as well.

For further reading, check out Understanding The Cash Conversion Cycle.

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