This column covers fundamental analysis, which involves examining a company’s financial
statements and evaluating its. The analysis concentrates only on variables directly related to
the company itself, rather than the stock’s price movement or the overall state of the market.
The Cash
Conversion
Cycle
Through the normal course of business, companies acquire inventory
on credit, which they in turn use to
create products. These products are
then sold, oftentimes on credit. These
actions generate accounts payable
and accounts receivable, with no cash
exchanged until the company collects
accounts receivable and settles the
accounts payable.
The cash conversion cycle (CCC)
measures the time—in days—that
it takes for a company to convert
resource inputs into cash flows. In
other words, the cash conversion
cycle reflects the length of time it
takes a company to sell inventory,
collect receivables, and pay its bills.
As a rule, the lower the number,
the better. This is because, as the
cash conversion cycle shortens, cash
becomes free for a company to invest
in new equipment or infrastructure
or other activities to boost investment return. Also, the cash conversion cycle can be useful in comparing close competitors and assessing
management efficiency.
Calculating the Cash
Conversion Cycle
ratios” related to the turnover in
inventory (accounts receivable), all
of which are expressed in days. The
formula for the cash conversion cycle
is as follows:
CCC = days inventory outstanding (DIO) +
days sales outstanding (DSO) – days payable
outstanding (DPO)
Days Inventory Outstanding
This measure addresses the question of how long—in days—it takes
for a company to sell its entire inventory. The smaller the number, the
better.
DIO = average inventory ÷ cost of goods sold
per day
Where:
Average inventory = (beginning inventory +
ending inventory) ÷ 2
Cost of goods sold per day = annual cost of
goods sold ÷ 365
Days Sales Outstanding
Here we calculate the number of
days a company needs to collect on
sales. Cash-only sales have a DSO
of zero, but many companies allow
customers to buy on credit. Again,
the smaller the number, the better.
DSO = average accounts receivable ÷ revenue
per day
The cash conversion cycle is actually a collection of three “activity
Where:
Average accounts receivable = (beginning
accounts receivable + ending accounts receivable) ÷ 2
Revenue per day = annual revenue ÷ 365
Days Payable Outstanding
Lastly, we measure how long it
takes for a company to pay its bills
(accounts payable). The longer a
company is able to hold its cash, the
better its investment potential. In this
case, a longer DPO is better.
DPO = average accounts payable ÷ cost of
goods sold per day
Where:
Average accounts payable = (beginning accounts payable + ending accounts payable)
÷2
Cost of goods sold per day = annual cost of
goods sold ÷ 365
Table 1 presents data for American
Eagle Outfitters (AEO), a casual
apparel chain, covering its last seven
fiscal years. The top of the table provides the annual income statement
and balance sheet data needed to
calculate the three activity ratios and,
ultimately, the cash conversion cycle.
Time Series Analysis
Analyzing financial ratios on
a stand-alone basis doesn’t yield
meaningful results. Instead, tracking
trends in an individual company over
several years, as well as comparing
Table 1. Calculating Cash Conversion Cycle
American Eagle Outfitters (AEO)
Revenue
Cost of Goods Sold
Inventory
Accounts Receivable
Accounts Payable
Average Inventory
Average Accounts Receivable
Average Accounts Payable
Days Inventory Outstanding
Days Sales Outstanding
Days Payable Outstanding
Cash Conversion Cycle
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2010
2,990.5
1,832.5
326.5
34.7
158.5
310.7
38.1
155.3
61.9
4.7
30.9
35.6
2009
2,988.9
1,814.8
294.9
41.5
152.1
290.7
36.7
155.0
58.5
4.5
31.2
31.8
2008
3,055.4
1,632.3
286.5
31.9
157.9
275.1
29.0
164.6
61.5
3.5
36.8
28.2
2007
2,794.4
1,454.0
263.6
26.0
171.2
237.2
27.6
155.2
59.5
3.6
39.0
24.2
2006
2,322.0
1,244.2
210.7
29.1
139.2
190.7
27.8
124.1
55.9
4.4
36.4
23.9
2005
1,881.2
1,003.4
170.6
26.4
108.9
145.6
25.3
90.1
53.0
4.9
32.8
25.1
2004
1,435.4
885.9
120.6
24.1
71.3
Computerized Investing
Table 2. Comparing Cash Conversion Cycles Among Competitors
American Eagle Outfitters (AEO)
Days Inventory Outstanding
Days Sales Outstanding
Days Payable Outstanding
Cash Conversion Cycle
Abercrombie & Fitch (ANF)
Days Inventory Outstanding
Days Sales Outstanding
Days Payable Outstanding
Cash Conversion Cycle
Urban Outfitters (URBN)
Days Inventory Outstanding
Days Sales Outstanding
Days Payable Outstanding
Cash Conversion Cycle
2010
61.9
4.7
30.9
35.6
2009
58.5
4.5
31.2
31.8
2008
61.5
3.5
36.8
28.2
2007
59.5
3.6
39.0
24.2
2006
55.9
4.4
36.4
23.9
2005
53.0
4.9
32.8
25.1
2010
124.7
9.0
35.5
98.2
2009
114.8
5.6
31.8
88.6
2008
114.6
4.8
31.5
87.8
2007
130.0
4.7
30.8
103.8
2006
114.6
5.3
34.0
85.8
2005
116.9
4.1
38.1
82.9
2010
56.4
7.0
22.3
41.1
2009
55.6
6.2
22.3
39.6
2008
64.0
5.7
25.9
43.8
2007
69.6
5.2
23.4
51.4
2006
67.9
3.8
22.8
48.9
2005
60.5
3.3
24.8
39.0
these trends to key competitors, can
prove enlightening.
From the data in Table 1, we see
that American Eagle’s cash conversion cycle has risen almost 42%
since 2005, from 25.1 days to 35.6
days. This trend is not favorable for
the company, as money is tied up
for longer periods of time before the
company is able to convert its own
expenditures back into cash.
Looking at the three activity ratios
that make up the cash conversion
cycle, we can further dissect the cash
conversion trend. From Table 1, it
appears that the biggest contributor
to the rise of the cash conversion
cycle for American Eagle is days inventory outstanding, which has risen
from 53.0 days to almost 62 days
since 2005. This means that the company is having a harder time turning
over its inventory.
The days sales outstanding ratio has
been relatively stable over the entire
period, but it has risen from 3.5 days
in 2008 to 4.7 days in 2010. This
may mean that the company is relaxing its collection policies or extending
credit to customers who are having a
hard time paying.
Lastly, days payable outstanding has
fallen only slightly since 2005, but
Second Quarter 2011
has seen a sizable decline from 39.0
days in 2007 to 30.9 days in 2010.
Unlike the other two activity ratios,
a longer days payable outstanding is
preferable. This may be an indication
of creditors tightening their terms
with American Eagle.
Competitive Analysis
When comparing the cash conversion cycle across companies, it is
important to compare companies
within the same industry. Otherwise,
your analysis may not be helpful.
Table 2 shows the activity ratio and
cash conversion cycle data for American Eagle along with Abercrombie
& Fitch (ANF) and Urban Outfitters
(URBN). The three companies are in
direct competition with each other, so
we are making a meaningful comparison.
American Eagle has the lowest
cash conversion ratio value at 35.6
days, followed by Urban Outfitters
(41.1 days) and Abercrombie & Fitch
(98.2 days). Urban Outfitters has
been able to lower its cash conversion cycle from 51.4 days in 2007 by
significantly increasing its inventory
turnover: its days inventory outstanding has fallen nearly 20% from 69.6
days in 2007 to 56.4 days in 2010.
Abercrombie & Fitch takes more
than twice as long to turn over its
inventory as Urban Outfitters and
American Eagle. The company’s
days inventory outstanding stands
at 124.7 days, although it has fallen
from a high of 130.0 days in 2007.
Abercrombie’s days sales outstanding jumped from 5.6 days in 2009
to 9.0 days in 2010. This means that
customers are taking significantly longer to pay for their purchases. Both
factors are contributing to Abercrombie’s cash being tied up nearly three
times as long as that of American
Eagle and more than twice as long as
that of Urban Outfitters. This does
not reflect well on Abercrombie in
regard to management’s efficiency
relative to some of its competitors.
Conclusion
The cash conversion cycle is a useful tool in evaluating a company’s
management. By breaking down the
cash conversion cycle into its three
component activity ratios and studying the trends in individual companies, as well as comparing direct
competitors, you can gain insights in
the operating efficiency of a firm.
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