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.

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!