Cash Conversion Cycle
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
Jewelry retailers, bookstores, and toy distributors increase sales
markedly just before the holiday season.
 Retail department stores and candy retailers follow the same pattern.
 Garden outlets, sporting goods stores and home lumber dealers
experience peak sales during warm spring and summer months.

Retail businesses use seasonal loans to support swings in sales activity.
Clothing stores anticipate increases in volume in the spring and again in
the fall as new lines arrive.
 Retail firms borrow heavily during the Christmas and Easter seasons to carry
increased inventories and accounts receivable.

Steel operations on the Great Lakes usually build iron ore inventories
during summer months to supply their needs during winter when lake
freighters cannot transport raw materials because of inclement weather.
2

Swimsuit manufacturers start producing bathing suits in fall for spring
distribution to retailers.
 During the manufacturing phase, inventories build along with labor, overhead,
other product costs. In the spring swimsuits are sold. Shortly thereafter,
receivables fall due with proceeds providing the annual (loan) cleanup.

Building contractors achieve higher levels of production when weather is
favorable.

Forest products producers build substantial log inventories to keep
manufacturing plants supplied with raw materials during seasons when
logging operations make little headway.
3

Coal and fuel oil dealers build inventories in during summer
months, running them off steadily in fall and winter to a low
point by early spring.

Food processors use short-term lines to finance crops grown
and shipped at distinctive seasons.
 Short term financing supports fertilizer and other production costs
and the harvesting season for distribution and marketing of the crop
(see Chapter 5).

Fish canneries must do their processing as the fish are
caught, which often results in the accumulation of
substantial inventories
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Buildup Period
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
During the buildup period, demand deposits drop whereas loan
balances, trade payables and inventory increase. At this point, the
balance sheet begins to expand.
High Point
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
As a company reaches its high point, inventory, bank debt, and
trade payables reach a peak. The need for liquidity bottoms out,
and receivables remain low. The balance sheet reaches expansion
limits.
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Conversion Cycle Begins


Inventory decreases and receivables increase as demand
strengthens. Payables and bank debt remain steady or decline
slightly. The balance sheet moves in tandem with the reduction in
liabilities.
Conversion Cycle Intensifies


Shipments accelerate causing inventory to decline quickly and
receivables to build further. Demand deposits rise, but at a slower
rate as some receivables convert to cash. Payables and short-term
loans begin to fall faster as collections are converted into cash.
Balance sheet contraction moves in tandem with cash conversion.
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
Conversion Cycle Subsides
 The low point approaches. Firms ship very little
merchandise. Inventory is already at low levels
and receivables decline quickly, since the
conversion process causes deposits to swell. The
balance sheet fully contracts to its low point as
trade payables and bank debt are retired or
cleaned up. After the “traditional 30 days” have
passed, renewed debt replenishes the account in
preparation for next season.
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8

Sometimes things go wrong – inventories
haven’t been sold. At season’s end these
obligors may not have cash available to zero
out credit lines. The process generally follows
a repetitive pattern
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10

Seasonal Ratio Analysis
 Cash + Receivables/STD + Payables
 Returns/Gross Sales

Cash Budgets
 Open cash budget link

Trial Balance Analysis
 Break Even Shipments
 Break Even Inventory
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
One of the most effective tools used to derive
peak short term financing requirements are
cash budgets.
 Cash budgets usually span short periods -
monthly, quarterly, semiannually, annually
 Short-term budgets pinpoint both borrowings
required and timing of repayments.
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
Provide lenders with a way to monitor
seasonal activity.
 For example, if actual cash receipts fall below
planned receipts, bankers may assume that
management either missed revenue targets, or
goals were unrealistic to begin with.

Help determine appropriate credit lines or
loan ceilings.
13

Spot months bankers can reasonably expect
loan reductions. If additional drawdowns
replace loan repayments – watch out –
inventory likely did not sell.

Identify wayward deployment of seasonal
advances.
14

Work as quasi-marketing tools. For instance,
capital expenditures normally call for
considerable cash outlays during the budget
period. If the bank spots these anticipated
outlays early enough, they can sponsor term
loans or other facilities before the client
approaches another bank or leasing
company.
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Preparing a Cash
Budget (Refer to
Acme’s Cash Budget)
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
Trial Balance Analysis
 Qualitative Analysis
▪ Storm Signal Analysis
 Quantitative Analysis
▪ (Cash + Accounts Receivable)/(Short term Bank Debt +
Trade Payables)
▪ Returns and Allowances/Gross Sales
▪ Purchases/Sales
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Slow in-house orders in comparison to
corresponding periods in previous years.
Factory operating well below capacity.
Changes in the manner payables are paid.
Owners no longer take pride in their business.
Frequent visits to the customer’s place of business
reveals deteriorating general appearance of the
premises.
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Example, rolling stock and equipment has not been
properly maintained.
Loans to or from officers and affiliates.
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
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Management does not know what condition the
company is in and the direction in which it is
headed.
The lender did not examine the obligor’s cash
budget and as a result overestimated seasonal
peaks and valleys thereby approving an excessive
loan.
Inability to clean up bank debt or clean ups
effected by rotating bank debt.
Unusual items in the financial statements
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
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Negative trends – losses, weak gross margins,
slowness in accounts receivable, and decrease in
sales volume.
Intercompany payables/receivables are not
adequately explained.
Cash balances reduce substantially or are
overdrawn and uncollected during normally liquid
periods.
Management fails to take trade discounts because
of poor inventory turnover.
Cash flow problems – very low probabilities
operating cash flows cover debt service.
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
Withholding tax liability builds as taxes are used to
pay other debt.
Frequent “downtiering “ of financial reporting
sparked in an effort to bring on a more “liberal”
accountant.
Changes in financial management.
Totals on receivables and payables aging schedules
do not agree with amounts shown on the balance
sheet of the same date.
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At the end of the cycle, creditors are not completely paid
out.


Sharp reduction in officers’ salaries




The bank sometimes can be paid out when the borrower leans on
the trade. (This often gives bankers a false sense of security, but the
company may be unable to borrow from the trade for the next
buildup of inventory).
Brings a lower standard of living home, and might suggest a last
ditch effort to save a distressed business.
Reduced salaries might signal a concerted effort to make headway.
Erratic interim results signaling a departure from normal
and historical seasonal patterns
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The lender does not allow enough cushion for error. If the
seasonal loan is not repaid and there is no other way out
but liquidation of the collateral, the lender is taking
possession of collateral at the worst possible time. It is the
end of the season, and if the obligor cannot sell, how will
the bank?
Financials are submitted late in an attempt by
management or their accountants to postpone unfavorable
news.
Unwillingness to provide budgets, projections or interim
information.
Suppliers cut back terms or request COD.
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Changes in inventory, followed by an excessive inventory
buildup or the retention of obsolete merchandise.
The borrower changes suppliers frequently, or transient
buying results in higher raw material costs.
Increased inventory to one customer or perilous reliance on
one account.
Changing concentration from a major well-known
customer to one of lesser stature pointing to problem
inventory.

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
A good mix of customers is the best defense against “seasonal
shock therapy”.
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The lender permits advances on the seasonal loan
to fund other purposes, notably payments on the
banks own term debt. Indeed, the term debt is
handled as agreed, but the seasonal loan goes up
and stays up.
Company loses an important supplier or customer.
Concentrations in receivables and payables. Failure
to get satisfactory explanations on these
concentrations.
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
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Failure to conduct investigations on the credit worthiness
of larger receivables
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The lender finances highly speculative inventory
whereby the borrower is trying for a “home run.”
Intangible signals such as failure to look the banker
in the eye, letting the condition of the business
deteriorate, or taking longer to return calls.
Management orders three-pound lobsters during a
banker’s lunch because the bank is picking up the
check.




This weekend they won’t be able to afford this dish - the
firm has just gone off the cliff.
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
Prudently structured credits fall back on a second
way out, or, as the literature defines it – a good exit
strategy. T
 Temporary problems usually are not serious: the bank
simply waives the annual cleanup.
 If conditions are precarious, the bank may decide to
restructure the credit, that is, extend a term loan or
revolver to be repaid over the next few years out of
operating cash flows.
 A loan agreement, by virtue of its covenants and events of
default, will give the bank greater control over the credit.
Consider these important factors:
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 Cash Flow.
 Equity Injection.
 Formula Based Advances
 Credit Insurance.
.
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