Working Capital 101: Know your cash-conversion cycle

A company’s cash-conversion cycle is the amount of time it has merchandise in inventory plus the time it takes customers to pay them minus the time it takes to pay vendors.

Days sales in inventory (DSI) is calculated as inventory divided by one day of merchandise cost of goods sold (usually COGS excluding depreciation). This is basically how long merchandise sits on the shelf, in the warehouse and in transit.

DSI is a shorter period of time for more perishable inventory but can be months in the case of imported goods such as clothing.

Days sales outstanding (DSO) is calculated as accounts receivable divided by one day of sales. This is how long it takes customers to pay and is usually only a few days for credit card processing in a consumer-facing businesses. For companies providing credit directly to their customers, however, it can be much longer.

For a wholesale vendor, these are the terms given to the retailer, and rising DSO shows that the vendor is shipping product to the retailer but not being paid.

Days payables outstanding (DPO) are calculated as accounts payable divided by one day of cash operating expenses. This is basically the average payment term to vendors and can include payroll expenses, which are usually under 14 days. For the retailer, this is what they owe to vendors and employees – and rent expense if the lease liability is included in accounts payable.

DSI + DSO – DPO = cash-conversion cycle, or the amount of cash the business needs for working capital.

For example, a retailer buys merchandise from a vendor with 30-day-payment terms. The retailer puts the merchandise on the shelf and it takes 50 days to sell. It then takes another four days to receive payment from the customer’s credit card bank settlement.

The retailer gets the merchandise on Day One, pays for the merchandise on Day 30, sells the merchandise on Day 50 and then receives cash from the customer’s credit card bank on Day 54.

In this example, the retailer’s conversion cycle would be DSI 50 + DSO 4 – DPO 30 = 24, which is the financing of working capital from Days 31 through 53. This company thus must have 24 days of capital tied up as merchandise on the shelf.

To reduce the cash tied up in working capital, the company can either sell the merchandise more quickly and/or pay the vendor later and/or require cash from the customer rather than a credit card.

Red and green flags: What can we glean from DSIs, DSOs, and DPOs?

As a company grows its sales (and assuming the cash-conversion cycle doesn’t change), the dollars of working capital will increase, which can be a surprise for companies that have not planned for the additional working capital required for growth.

Seeing changes in the days can also indicate strength or trouble at the companies and show which have planned for financing the additional working capital of revenue and profit growth.

An increasing DSI consumes cash and shows the company is getting less efficient with inventory. At the very least, more capital will be required, and at the very worst, it shows the company is having trouble selling the inventory and that a write-down of unsalable or perished inventory could occur.

A declining DSI generates cash and shows more efficient inventory management. This means the company can grow faster with less capital or generate cash from reducing inventory.

If you can get the same $12 million of sales by selling $4 million of inventory three times instead of $12 million of inventory once, that lets you redeploy the other $8 million elsewhere.

Increasing DPO generates cash and shows the company has bargaining power over its vendors, but it is a red flag if it gets too high and shows the company cannot pay its vendors.

Pushing suppliers works only up to a point; vendors will eventually cut off supply for nonpayment or go out of business themselves. All companies need a healthy supply chain to function, so you want to see DPOs that are not close to zero (indicating weakness vis-à-vis suppliers) but not excessive (indicating suppliers may cut off supply).

A declining DPO shows the company has less power over vendors, and it consumes cash. If DPO shows a decline from reasonable levels, it might show vendors are demanding payment sooner and are worried about cash flow issues at the company – which should worry investors as well.

An increasing DSO indicates the company is providing credit to customers, which consumes cash. It is a big red flag if DSO expands too quickly, as it shows the company is using vendor credit to drive sales. Customers have bargaining power, or the company might be taking customer credit risk that traditional lenders will not accept. There is the risk that the rising accounts receivables will eventually be written off as an uncollectable bad debt expense.

A declining DSO shows that a company has in-demand product and is generating cash. It shows that customers will pay cash for the product, even if the customer has to procure the financing elsewhere.

Mike Regan can be reached at [email protected].