Managing Short-Term Assets and Liabilities for Corporate Health
The Cash Conversion Cycle measures the time it takes for a company to convert its investments in inventory and other resources into cash from sales. It's a key indicator of operational efficiency.
The time from acquiring raw materials to collecting cash from customers. It encompasses inventory production, sales, and receivables collection.
This refines the operating cycle by factoring in the company's payment schedule to its own suppliers.
Average number of days inventory is held before being sold.
Average number of days it takes to collect cash from sales.
Average number of days the company takes to pay its suppliers.
Illustrative Example: Calculating CCC
A company has DOH of 60 days, DSO of 45 days, and DPO of 50 days.
Calculation:
CCC = 60 (DOH) + 45 (DSO) - 50 (DPO) = 55 days.
Conclusion: It takes this company 55 days to turn its inventory investments into cash. A shorter CCC is generally better, indicating efficient management. A negative CCC is excellent, meaning the company receives cash from customers before it has to pay its suppliers.
Optimize inventory levels, reduce slow-moving products, and use frequent deliveries.
Offer prompt payment discounts, enforce late payment penalties, and tighten credit terms.
Negotiate longer payment terms with suppliers.
Working capital measures a company's short-term operational liquidity.
Current Assets - Current Liabilities
A more refined measure, typically excluding cash and short-term debt.
(Current Assets - Cash & Securities) - (Current Liabilities - Short-term Debt)
A high working capital-to-sales ratio might indicate inefficiencies like aging inventory. Generally, holding less working capital is preferred so that funds can be invested in higher-return projects.
Companies balance risk and cost when deciding how to fund their working capital needs:
Relies more on stable but expensive long-term funding. Holds more current assets. Preferred for companies in early-growth stages or with unpredictable cash flows.
Uses more cheap but risky short-term funding. Holds fewer current assets. Suitable for companies with stable and predictable sales.
A balanced approach, mixing long- and short-term funding to optimize cost and risk.
Liquidity refers to a company's ability to meet its short-term obligations. It is managed by drawing from primary and secondary sources of cash.
Cash and marketable securities
Cash flow from operations
Available borrowing capacity (e.g., credit lines)
These are typically used when primary sources are exhausted and may signal financial distress.
Suspending dividends
Selling assets
Issuing new equity
Bankruptcy protection
Factors that reduce or slow down cash inflows (e.g., uncollected receivables, obsolete inventory)
Factors that accelerate cash outflows (e.g., making early payments to suppliers, reduced credit limits from banks)
Analysts use several ratios to evaluate a company's liquidity position. Higher ratios generally indicate a stronger ability to meet short-term obligations.
| Ratio | Formula | Interpretation |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | The most basic measure of liquidity |
| Quick Ratio (Acid-Test) | (Cash + Securities + Receivables) / Current Liabilities | A more stringent test that excludes less-liquid inventory |
| Cash Ratio | (Cash + Securities) / Current Liabilities | The most conservative measure, showing ability to pay obligations without selling inventory or collecting receivables |
Effective management of short-term funding is crucial for maintaining flexibility and minimizing borrowing costs.
Avoid reliance on a single lender to maintain financial flexibility
Ensure adequate funding to accommodate varying cash needs throughout business cycles
Secure competitive rates and favorable terms to reduce financing expenses
Larger firms typically have more funding options than smaller ones
A strong credit profile leads to better loan terms and lower rates
Less developed legal systems may limit options, forcing greater reliance on trade credit
Suitable collateral can provide access to secured funding options