On the use of the cash conversion cycle in working capital analysis and credit analysis

On the use of the cash conversion cycle in working capital analysis and credit analysis

Walker, Matthew A


The cash conversion cycle (CCC) is a concept and method of analysis that is covered in most introductory finance textbooks and bank management textbooks. It is purported to measure the number of days between cash outflows and cash inflows, and has been used as a liquidity measure and a measure of short-term financing needs. The technique for measuring the CCC varies somewhat from book to book as does its interpretation and its suggested uses. This paper illustrates the problems involved with computing and using the CCC. It is shown that the results of the computation are ambiguous, difficult to interpret, and not of much use in providing input to the financial planning process and to performance measurement.


A common topic that is covered in most introductory financial management textbooks is a measure and method of analysis known as the “cash conversion cycle,” (CCC) which has also been referred to as “cash-to-cash working capital cycle” or simply the “cash cycle.” The method was first developed by Richards and Laughlin (1980) and has been included in many textbooks since that paper first appeared. The subject is treated in several bank management texts as well as textbooks that focus on short-term financial management.

The method purports to measure, in days, the average length of time between the outflow of cash associated with the purchase of productive inputs for a particular good or service and the inflow of cash associated with the sale of the output and the resulting collection of accounts receivable. The measure has been interpreted in a number of different ways by the authors of the textbooks. There is no agreement on any one interpretation or on the correct uses of the CCC. When presenting this type of analysis to students in introductory finance classes and bank management classes, I have struggled to provide an answer to a question that is frequently posed by the more inquisitive students: just what, exactly, are we to do with the measure once it is calculated? Given the range of interpretations found in the aforementioned textbooks, a clear-cut answer to this question does not emerge.

This paper clarifies what it is that is being measured in CCC analysis. It shows that the method should be used only as an approximation to the level of net working capital within a firm and is not appropriate when used for any other purpose. It is shown that the CCC is measured in “commingled” units which makes it difficult to interpret in terms of a number of days and renders it inappropriate for conversion into a dollar amount that may be used as input to financial decision making, such as determining the proper amount of loan needs at any point in time, or estimating future working capital requirements.

This article is organized as follows. The second section contains a summary of working capital cycle analysis as it is presented in the seminal paper by Richards and Laughlin (1980). The summary is extended to include the most common uses of this method of analysis in recent introductory financial management textbooks and bank management textbooks. The third section contains a specific analysis of each component of the “working capital cycle” from which the CCC is derived, and the inappropriateness of some of the uses of this type of analysis will be illustrated. The fourth section will conclude with some suggestions for the appropriate use of the CCC, and the use of other methods in working capital management that may be more accurate and unambiguous in the measurement of liquidity.

Working Capital Analysis and The Cash Conversion Cycle

In their seminal paper, Richards and Laughlin (1980) devised a method of working capital analysis known as the cash conversion cycle (CCC) as part of a broader framework of analysis known as the “working capital cycle” It is claimed that the method is superior to other forms of working capital analysis that rely on ratio analysis or a decomposition of working capital. The CCC is calculated by subtracting the payables deferral period (360/annual payables turnover) from the sum of the inventory conversion period (360/annual inventory turnover) and the receivables conversion period (360/annual receivables turnover). More recently, the number of days per year that appears in the denominator as 360 has been replaced by 365 to improve accuracy. Since each of these three components is denominated by some number of days, the CCC is also expressed as a number of days. It has been interpreted as a time interval between the cash outlays that arise during the production of output and the cash inflows that result from the sale of the output and the collection of the accounts receivable. It has also been used as an estimate of “the average length of time a dollar is tied up in current assets” by Brigham (1993, p. 703), as an estimate of the amount of shortterm funds that are financed with loans and long-term or non-spontaneous sources of capital by Moyer, McGuigan and Kretlow (1992, p. 659), and as an estimate of working capital loan needs when multiplied by a firms average daily cost of goods sold by Koch (1992, p.647-8).

While Richards and Laughlin correctly point out the limitations of the current and quick ratios in liquidity analysis, and how cash flow coverage rather than the liquidation value of assets should be the primary focus in liquidity analysis, they don’t address some of the problems involved in using the CCC for the same purpose. These problems are analyzed in the next section. In addition, Richards and Laughlin provide a number of reasons why the CCC is a better measure of liquidity as it considers all cash flows arising from the basic activities of a firm. They also discuss how it is possible that higher levels of current and quick ratios can result from a longer CCC and will reflect a buildup of less liquid forms of current assets, which would indicate less liquidity from a cash flow standpoint. While this may be true, it will not necessarily be so due to the deficiencies in the computation of the CCC and the difficulty involved in its use. It is shown below how the CCC can also give misleading indications of liquidity.

Hempel, Coleman and Simonson (1990, p. 444) present a slightly modified version of the CCC where the inventory conversion period is replaced by average cash divided by net sales per day. It is called the “cash-to-cash cycle,” and is supposed to measure “the turnover rate of working capital,” or, “the time required for a single dollar to move through the working capital cycle.”

Schall and Haley (1991) present an analysis of a firm’s “Cash Cycle” in much the same way as other authors do, however they provide a more detailed description of the actual cash flows and show how the resulting measure is only an approximation of the period of time between the point where cash is paid out to suppliers and the point where cash is received by customers. The authors discuss the complexities involved in measuring actual flows, in terms of days, due to the lags involved in the collection and disbursement systems of most firms (i.e. “float”) which can be quite variable. The authors are also the only ones to mention that the analysis is simplest for those firms involved only in the distribution of goods as opposed to the manufacture of goods. This is because the manufacturers have several types of inventory that can be measured either at cost, or at sales. This complexity is discussed in a later section.

Finally, Kamath (1989) discusses the use of the CCC in working capital analysis in general, and in the assessment of liquidity in particular. It is claimed that the CCC can be used with another related measure, the “net trade cycle,” (which is calculated quite similarly to the CCC except that all dollar amounts are measured in terms of sales dollars) to more accurately assess a firms liquidity position. Although the analysis presented in Kamath is helpful in that it addresses the problem of measurement units in the CCC, other problems with its use and implementation remain.

Problems Involved in the Measurement and Interpretation of The Cash Conversion Cycle

The unit of measure of the resulting number is days, as the 360 in each of the denominators represents, roughly, the number of days in a year. Another way of interpreting the three components is that each one represents a ratio of two dollar amounts multiplied by a number of days. The first component is then the ratio of inventory to sales times 360 days, the second term is the ratio of receivables to sales times 360 days, and the third component is the ratio of payables to sales times 360 days. In the first two terms all dollar amounts are expressed in sales dollars, while in the third the dollar amounts are in terms of costs. The problems inherent in this model of the CCC will now be explored.

Completeness and Consistency

First, the basic formula provided by Richards and Laughlin does not take into account two other working capital accounts that should be included in the analysis for most firms: cash and accruals. Koch (1992) has broadened the CCC computation to include these two accounts by adding the number of days accruals (current accruals/average daily operating expenses) to the number of days payables and by adding the number of days cash (current cash/average daily sales) to the sum of the inventory conversion period and the receivables conversion period. While the measurement used in Koch corrects for a portion of the error in the original Richards and Laughlin specification, it still leaves out some current asset accounts and current liability accounts that may be found on some firms balance sheets. Examples would be the current maturity of long-term debt and pre-paid expenses.

Gitman and Sachdeva (1982) provide a more detailed model, which they call the “working capital cycle,” that contains a complete specification of all components of inventory, but it too suffers from the other problems discussed above and below. The point here is that no general formula can be developed to handle all types of firms and the accompanying intricacies of their current asset and current liability accounts. If the CCC is supposed to represent the extent to which current assets will be financed with long-term sources of funds, the measurement should take into account all, or nearly all, of the current asset and current liability accounts. The more common types of liquidity measures, liquidity ratios and net working capital, do not suffer from these problems.

Another problem occurs when attempting to interpret the CCC as a number of days, and have the interpretation be meaningful, as the calculation commingles different units of measurement. The first two terms in Equation 1 are consistent as they represent the number of days sales in inventory and receivables which are both measured at sales value (or at least it is possible for firms to do so). Wholesaling and retailing firms find it easy to value their inventory in sales dollars. However, the final term represents the number of days payables and is measured in terms of the firm’s costs, and will be inconsistent with the previous two terms. It is not possible to simply subtract it from the previous two lengths of time without first adjusting for the markup from costs to sales, which may be different for some types of purchases than others. If we compound this with the fact that inventory for many firms is composed of raw materials, work-in-process and finished goods, some of which are valued at cost and some at sales, there is even more ambiguity in the resulting CCC measure.

Problems with the Use and Interpretation of the CCC

Koch (1992) implies that the CCC can be used as a measure of working capital loan needs by multiplying the CCC by the firm’s average daily cost of goods sold. This is erroneous for several reasons. First, as was shown above, the resulting figure that is calculated using either the simplest method of computation shown in equation 1 (the Richards and Laughlin CCC), or the more complicated methods that include more current asset and current liability accounts (as in the Gitman and Sachdeva model) is a result of using at least two units of measurement that make it inappropriate to add these measures together or to subtract one measure from another.

Second, even if all units were consistent (as in the Kamath model where all dollar amounts are sales dollars), when multiplying the CCC by average daily cost of goods sold, we end up with a number that most closely resembles net working capital, or, the amount of current assets that are financed by non-current sources of funds plus short-term bank loans (sometimes referred to as “non-spontaneous” sources of financing). This is the same type of interpretation given by Moyer, et al. (1992, p. 659). However, a much easier method is available and it provides the same type of information and is easier to calculate and interpret, namely, net working capital. As the CCC gets large (small), so will net working capital, generally. This assumes that a more complete measure of the CCC is used. The point is that net working capital does not measure current needs for shortterm funds. It simply measures the current utilization of long-term sources of funds in financing short-term assets. If net working capital doesn’t indicate needs for funds, then neither will the CCC. A more appropriate method of determining loan needs would be to perform a pro forma analysis using the percent-of-sales method.

Hempel, Coleman, and Simonson discuss an even simpler measure of the “cash-to-cash” cycle and explain that it can be interpreted as the “turnover rate of working capital.” (1990, p. 444). Their computation involves adding the number of days cash to the average collection period plus the number of days inventory. They do not provide any specific method by which the measure can be used to provide any concrete information for a loan analysis. Their specification suffers from the problems outlined here as well as an oversimplification involved in the computation. A Numerical Example

To illustrate the point made in the previous paragraphs, a hypothetical example is presented in Exhibits 1 and 2. This example uses the balance sheets and income statement items for a typical operating company before and after an arbitrary 50% growth in assets and sales to show the relationship between the CCC, net working capital, short-term loans and various liquidity measures. The example was designed to illustrate the interpretation of the CCC after a period of growth in which assets grow by a certain percentage while current liabilities grow by a much smaller percentage than assets. This is done purposefully to lengthen the CCC and provide a useful tool for analyzing the change in the CCC compared to changes in other balance sheet accounts and liquidity measures. This is also consistent with the assumptions that are usually made when planning for growth in a firm and when using the percent of sales method as a tool in financial planning.

Although it may be argued that it is not always the case that assets increase proportionately with sales, in the long run a doubling of output will require a doubling of assets, consistent with the microeconomic principle that all costs are variable in the long run. Most long-term financial planning models will build this assumption into the construction of pro forma financial statements and it is not unreasonable to do so in this example. It is also possible that current liabilities will maintain a constant proportion of sales, instead of the assumption used here, however most textbooks agree that only the “spontaneous” current liabilities maintain proportionality. Exhibit 1 contains the “before” balance sheet together with net sales and annual purchases from suppliers. Using these figures the CCC is 29.7 days. When multiplied by average daily cost of goods sold, as suggested by Koch (1992) the resulting dollar figure is 214.50, which is much less than notes payable. This figure has little to do with short-term loan “needs.”

When the CCC is multiplied by average daily sales, the result is $709.50 which is supposed to represent the extent to which current assets are financed by non-spontaneous sources of funds (notes payable, long-term debt and equity). However, this figure can be calculated directly by adding notes payable to net working capital, as has been done in Exhibit 1, and the result is $1,400, or about twice the level of CCC times average daily sales. For purposes of comparison with data from after the growth in assets, the standard liquidity measures, the current ratio and the quick ratio, are shown at the bottom of Exhibit 1.

Exhibit 2 shows the same type of information as Exhibit 1 for our hypothetical firm after a 50% growth in all asset accounts, sales and purchases. As an illustration of how the CCC is not necessarily a superior measure of liquidity, notice that in Exhibit 2: 1) the CCC has increased from 29.7 to 34.3 days, a 15.5 percent increase, 2) net working capital has increased 75.6 percent, 3) the amount of current assets financed by non-spontaneous sources of funds has increased by 55.7 percent, 4) CCC multiplied by average daily cost of goods sold has grown by 73.2 percent and CCC times average daily sales has grown by the same percentage, 5) net working capital has increased from $900 to $1,580, a 64.4 percent increase, while the ratio of net working capital to assets has increased from .2045 to .2394, 6) the increase in the current ratio is 17.9 percent and 7) the increase in the quick ratio is 18.2 percent.

Of greatest importance is that the CCC, by itself or when multiplied by average daily sales or purchases, moves in the same direction as net working capital and related measures. However, the correlation in movements is imprecise and depends on many other variables. Further, while the proponents of the CCC indicate that it can be a superior measure of liquidity, it can be argued that in this hypothetical example, the CCC increased (which is supposed to signal deteriorating liquidity) while current and quick ratios improved as did the amount of net working capital and the ratio of net working capital to assets. It is argued that with more liquid assets relative to current liabilities and assets, the liquidity position of this hypothetical firm has indeed increased, and has not deteriorated. The firm’s ability to generate cash to meet expenses has improved. Furthermore, this firm’s need for short-term financing has not increased, but rather, its utilization of long-term financing has increased, as illustrated by the 66% increase in long-term debt. In other words, a lengthening of the CCC will quite possibly lead to a stronger reliance on permanent (or at least non-spontaneous) sources of capital, and little else can be said.

Of course, other examples could be constructed to show different results, but the purpose here is to show the possibility that the CCC may not always measure what it is intended to measure. Also, the typical firm experiences growth in assets that is not necessarily matched by a corresponding growth in spontaneous liabilities, or the growth is delayed. This is the situation that was depicted in the example and the results of this example are not unusual.

Summary and Recommendations

This paper has shown that the mechanics of the calculation of the cash conversion cycle, and several other variations of the measure, have rendered the measures inaccurate and difficult to interpret. Although the measures will improve as more current asset and current liability accounts are included in the measures, perfect accuracy is never possible due to the fact that different units of measurement are being commingled in the calculations.

Even if there were a way to measure the actual time period with complete accuracy, its usefulness in financial analysis is in doubt. First, it is only roughly related to two more common measures of a firm’s utilization of funds: net working capital and utilization of non-spontaneous sources of capital. There may be no relationship between the CCC and short-term loan needs, or any common measures of liquidity.

As was mentioned in the previous paragraph, the CCC might have some usefulness in financial analysis as a measure of the extent to which a firm utilizes long-term and non-spontaneous sources of funds. If one could predict changes in the CCC, one could predict changes in the need for various types of funds and financial planning could be made simpler. However, being able to predict changes in the CCC would be no different than being able to predict changes in current asset and current liability accounts, and hence, the growth rates in those accounts. It is simpler and more direct to use those growth rates in a pro forma analysis using the percent-of-sales method. This method generally assumes that most assets and some current liabilities increase proportionately with sales while the other accounts don’t. Any necessary increases in the other balance sheet accounts must be anticipated and planned in advance in order to avoid constraints on growth caused by inadequate capital. As was mentioned, all that is needed to conduct this type of analysis is an estimate of growth. The analysis is much more accurate, is unambiguous, and is the preferred method.

The cash conversion cycle has use only in demonstrating the concept of cash flows within a firm, and should not be used in financial analysis and planning. Its interpretation as a turnover rate or as the length of time a dollar is tied up in working capital can be used to illustrate the basic idea of the working capital cycle, but should not be used to estimate dollar amounts for any balance sheet accounts. The CCC can also be used to compare one firm to another (i.e. in static analyses) to illustrate differences in the utilization of non-spontaneous sources of capital in financing current assets.

Dr. Mathew A. Walker is the Assistant Professor of Finance for the College of Business Administration at North Dakota State University, P.O. Box 5137, Fargo, ND 58105-5137

Copyright Credit Research Foundation Third Quarter 1998

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