The cash conversion formula takes into account the length of time between cash expenditures and cash receipts. The cash conversion formula is important to understand because it determines the average amount of time for an entire cash cycle to pass (from project start to final customer payment).
The formula for the cash conversion cycle involves the use of the inventory conversion period, receivables collection period, and the payables deferral period. The conversion period is typically derived from the related turnover ratio. For example, the inventory conversion period uses the inventory turnover ratio. The formulas will be listed below for ease of reference.
Cash Conversion Cycle = Inventory Conversion Period + Receivables Collection Period – Payables Deferral Period
1. Inventory Conversion Period
The Inventory conversion period measures the effectiveness of inventory management. Effectiveness is determined by the degree to which inventory is managed in relation to sales. The final measurement determines how many days of COGS are on hand.
Inventory Turnover = COGS/Average Inventory
Inventory Conversion Period = 365/Inventory Turnover
2. Receivables Collection Period
The receivables collection period measures the effectiveness of a company’s credit policy. The receivables collection period determines the length of time between when a sale is made and when payment is received.
Accounts Receivable Turnover = Sales/Average Accounts Receivable
Receivables Collection Period (Days Sales Outstanding) = 365/Accounts Receivable Turnover
3. Payables Deferral Period
The payable deferral period measures management’s ability to delay payment to vendors. In other words, the accounts payable deferral period measures the average delay between when a bill is received and when it is paid.
Accounts Payable Turnover = Sales/Average Accounts Payable
Accounts Payable Deferral Period = 365/Accounts Payable Turnover
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