By Puah Soon Lim
Today’s post is going to be about a question that I receive from one of my student at the recent weekend class at the SGX Academy. It concerns the CCC and its impact on a company’s liquidity. Specifically, this is the question that she asked:
“My calculations of the cash conversion cycle for Coy A is 179 days and for Coy B is (-74 days). Does a negative number indicate more liquidity? In this case, is Coy B more liquid than A?”
She did a calculation for CCC and for Company A, it is 179 days and for company B, it is a negative 74 days. She asked “Does a negative number indicate more liquidity? In this case, is Coy B more liquid than A?”
I feel that this is a good question to answer and I am going to answer it in this blog post. You may also write to us at this address and if we feel that this is a good question to answer, I will feature it in my blog post.
Just to give all of you a heads up, I have given two case studies in class which is company A and company B. You may download the pdf version of both case studies and also my calculation and follow along.
The basic understanding you need to have is this: CCC is about how fast you turn over cash. CCC allows you to see are you using other people’s money or are you allowing others to use your money.
Here is a picture of how the working capital cycle looks like.
We begin by taking inventory from our supplier which typically gives us credit, from inventory into customers hands, the customer paid us cash which we, in turn, is used to pay our supplier and that completes the entire cycle.
The length of this cycle really show how efficiently we are using other people’s money or the reverse, other people are using our money. In company A’s case, suppliers give an average of 39 days of credit, spend 195 days in inventory and the business gives 110 days in credit and we have a CCC of 266.17 days. As for company B, suppliers give 112 days of credit, stay 46 days in inventory and collect cash from customers for most items which explain why it only gives 9 days in credit to customers. Company B has a -57,17 days.
So what we have here is an example of two companies from two extremes. One is taking a long time to convert its cash. One is having an aggressive and positive use of suppliers’ money to finance its operations. What this means is that the company collect cash upfront, invests it for interest for a further 57 days before paying suppliers the money owed.
Most businesses do not have a negative cash conversion cycle. If they have, you need to check to make sure that numbers from past year indicate that it is the norm. Manufacturing operation can be expected to hold more inventory than Retailers and as such the difference in CCC.
What is the implication here for liquidity? Usually, if you have a high CCC, you need to have a certain amount of cash available, why? Because other people want to use your cash. The customer wants you to give credit. Supplier expects to be paid on time and doesn’t give you a lot of credit. And then you have money tied up in inventory. So some businesses do need to maintain a certain level of liquidity. It is not a surprise to see that such business need to maintain a current ratio of at least 1.5 times.
On the other hand, a business like company B doesn’t need a lot of cash on hand. It doesn’t give out credit, it collects cash from the customer and receives credit from suppliers and reinvest the extra liquidity that it has for extra interest return. So when you compute a current ratio for these type of companies, do not be surprised to find that it is below one.
It is important to understand the business to see why this is the case rather than trying to arrive at a number. That is why you have to Go Beyond The Numbers.
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