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EduPristine>Blog>A guide to using cash conversion cycle for stock analysis

A guide to using cash conversion cycle for stock analysis

June 7, 2018

Working Capital Management (WCM) is often considered of high strategic significance to generate cash and is impacted by Cash conversion cycle. It takes into account the duration in terms of a number of days taken by a company to convert its resources into cash flows. These help investors to track the efficiency of a company.

cash conversion cycle

A cash conversion cycle measures the amount of time it takes to convert the net input into sales. For this, look at the time needed to sell inventory, collect receivables and the duration for which company is afforded to pay its own bills without suffering penalties. CCC is a great tool which measures the total number of days cash is engrossed in working capital. It helps significantly in analyzing the competence of an organization in creating sales through cash management.

Cash conversion cycle analysis

Investors who compare close competitors look not only for the lower number of CCC but other metrics such as return on equity and return on assets. To understand how CCC helps investors to reckon the overall health of an organization, one must understand what CCC stands for. Cash conversion cycle incorporates various activity ratios ( AP, AR and inventory turnover) which are present on a balance sheet.

Here, account payable (AP) is a liability whereas inventory and account receivable (AR) are short-term assets which in turn reflects in ratios. These ratios further indicate the efficient use of liabilities and short-term assets in producing cash. These are not only important in academics but also provide essential information about working capital and efficiency of an organization. Therefore these cash conversion cycle ratios are regarded as the global financial performance index.

To understand how cash conversion cycle ratios are related to a business model, let’s take a look at these instances :

We know that if a company is meeting the specific demands of people, production of the company increases and therefore in that case, cash cycles very quickly across the business. But if the company is unable to catch consumer’s mind and detect the demand, CCC will slow down.

 

If a company puts too much investment around inventory, cash gets tied around goods that do not sell in the market and carries a bad news for the company. To quickly move the cash, the company might take a decision to sell even at a loss. The company can go further in loss because of delayed payment by customers or poorly handled AR. These can be balanced out by slowing down the payment, AP to the suppliers.

Calculating Cash Conversion Cycle

The formula to calculate CCC is:

CCC = DIO + DSO – DPO

 

Before looking at each part of the formula, calculate CCC. Let’s take an account of various other items from the financial statement. This includes COGS and revenue from income statement, AR, inventory, and AP (at the beginning and the end of specific time period) from balance sheets and the number of days in the specific time period.

DIO/DSO/DPO 

DIO stands for Days Inventory Outstanding and refers to days taken to sell inventory. Hence, smaller DIO is preferred. DSO means Days Sales Outstanding representing number of days needed to collect AR. Similar to DIO, small DSO number is also preferred. On the other hand higher DPO, Days Payable Outstanding is preferred as it refers to AP.

 

DIO = Average inventory/COGS per day

Average Inventory = (beginning inventory + ending inventory)/2

 

DSO = Average AR / Revenue per day

Average AR = (beginning AR + ending AR)/2

 

DPO = Average AP/COGS per day

Average AP = (beginning AP + ending AP)/2

 

Cash Conversion cycle and operating cycle

CCC and operating cycle are metrics representing the effectiveness of a company in cash management. While both OC and CCC perform a similar role, OC analyses companies working efficiency by representing the time a company takes in buying, selling the inventory and receiving the cash in exchange. Whereas, CCC provides an insight into the efficient management of cash flow by a company. Like CCC, shorter working cycles points to ideal cash flows and are desired. More often than not, one cycle impacts the other and it’s important to analyze them separately and together by companies for a better judgment of cash flows.

Stock market analysis

To analyze stock market through cash conversion cycle, it is imperative to understand all the parts of the CCC calculating formula and what they infer. For instance, If there’s an increase in Days Sales Outstanding (DSO) it means that customers are not paying on time and the collections are not properly managed. Similarly, a decrease represents unpredicted quicker payments.

Small numbers are in CCC are appreciated as in case of DIO as well but opposite in case of DPO. If a company represents its DIO in small numbers it means it is selling through inventory very quickly. On the other hand, the longer a company hold its cash and delays AP, the better.

Stock analysis depends on technical and fundamental analysis providing an evaluation of companies and market as a whole. The CCC model succeeds in analyzing a company’s liquidity where static measures fail. An examination of both static and CCC can provide in-depth analysis of a company’s liquidity.

The CCC does not directly affect the stock price or predict stock returns but can certainly help with stock picking. Business owners and accountants use the CCC ratio for a better understanding of business. By analyzing the historical trend of DSO, DPO and DIO of various companies one can understand the hidden catalyst and can identify the winning stock earlier. An analysis of the CCC ratio provides an all-around understanding of business. It is most effective with retail type companies.

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