Number of days' credit taken

In this case the figure for closing trade creditors is compared with that for the annual purchases.  

Annual costs of sales  $6 million
Trade creditors  $1.0 million
Number of days' credit taken

The calculation is (1.0 / 6.0) x 365 = 61 days

Number of days' credit granted

For example:

Annual turnover including GST  $10 million
Trade debtors $1.5 million
Number of days' credit  55

The calculation is:  (1.5 / 10) x 365 = 55 days

Obviously, the lower the number of days the more efficiently the business is being run.

The figure for trade debtors normally comes from the closing Balance Sheet and care should be taken that it is a figure typical of the whole year.

If $1.5 million of the $10 million turnover came in the final month, the number of days' credit is really 31 instead of 55.

The calculation is:  (1.5 / 1.5 ) x 31 = 31 days

Care should also be taken that the GST-inclusive debtors figure is compared with the GST-inclusive turnover figure.

GST is normally excluded from the Profit and Loss Account.



GST = General Sales Tax
In other countries, it is the VAT or Value Added Tax.

Keep an eye on the accounting ratios

These are always useful, but are particularly so if a business is in trouble.

You should know what is acceptable and you should monitor trends over a period.

If things are going wrong, this may spotlight the dangers and indicate where remedial action is needed.

Gearing and the number of days' credit given and taken may be especially useful.

Components of Cash Conversion Cycle

Cash Conversion Cycle (CCC)

Cash Conversion cycle is the time taken by a trading or manufacturing concern to realise cash from its inventory and account receivables after meeting its outflows owing to short term payables including trade creditors. 

It is expressed in terms of number of days and can be defined as follows in form of a formula:-

CCC= Days’ Inventory Outstanding (DIO) + Days’ Sale Outstanding (DSO) – Days’ Purchase Outstanding (DPO)

Components of Cash Conversion Cycle - DIO, DSO and DPO

Days’ Sale Outstanding (DSO)

DSO is the measure to assess the number of days a concern gives credit to its customers. Let us explain it with a formula:
DSO= Average receivables/ daily sale
Where
Average receivables: Opening balance + Closing Balance/2
Daily sales: Total annual sale/365

DSO can be calculated for every month as well. In fact when there is a revamp of credit terms then DSO should be computed for every month to understand the implication and drop or hike in DSO, as the case may be.

Days’ Purchase Outstanding (DPO)

DPO gives average credit term (days of credit) enjoyed by a concern from its trade creditors. In term of formula, it can be stated as follows:
DPO= Average payables/ Daily purchases
Where,
Average payables= Opening balance+ Closing Balance/2
Daily purchases= Total purchases/365
Just like DSO, DPO can also be computed monthly or any period of time as required.

Importance and usage of DSO and DPO

Now that we have discussed the meaning of DSO and DPO, let us understand their implication on a business and cash conversion cycle. 

Ideally, every trading concern must try to have a bigger DPO and smaller DSO, which essentially implies that they recover cash from debtors in shorter duration and pay off their creditors later.

For e.g. ABC Company has a DSO of 30 days and DPO of 40. This gives an advantage of 10 extra days to ABC Company to meet its payables and it enjoys healthy liquidity to meet its other production and day to day expenses as well.

DSO comparisons also help in effective credit control. If without any re-negotiations, a company observes that its DSO has risen then it means that the collection process is not working well. This situation can be rectified in many ways including putting processes like advance reminders and water tight system of invoicing in place for the starters. If a company has indeed renegotiated terms with both debtors and creditors, then the month on month DSO and DPO comparisons would show the result in line with such re-negotiations.

Days’ Inventory Outstanding (DIO)

The third pillar of CCC deals with inventory. DIO is the average days a trading concern takes to convert its inventory into sale and is stated as follows:
DIO= Average Inventory/ Day’s Cost of goods sold
Where,
Average inventory= Opening Balance + Closing Balance/2
Day’s cost of goods Sold (COGS)= Cost of goods sold/365
If the accounting period for which DIO is to be computed is shorter, then day’s COGS will be computed for such other period and 365 days will get replaced accordingly.

An Example

Cash Conversion Cycle (CCC) 

= (DIO + DSO) – DPO 
= (44 + 33) - 61

= 16 days

The above computation shows that the average days of credit granted by XYZ Corp is almost half at 33 days as compared to the credit days lent by it, which is 61 days.

The average days it takes XYZ Corp to sell its stock is 44 days and the number of days in which it converts its inventory and debtors into cash is just 16 days.

These figures picture a very liquid position of XYZ Corp where it is able to meet its able to generate working capital very efficiently.     

Ideally, every trading concern must try to have a bigger DPO and smaller DSO, which essentially implies that they recover cash from debtors in shorter duration and pay off their creditors later.

http://www.investorwhiz.com/concepts/understanding-working-capital

Operating Cash Flow: Better Than Net Income?

Operating Cash Flow: Better Than Net Income?

Posted: Oct 4, 2010
Rick Wayman


Operating cash flow is the lifeblood of a company and the most important barometer that investors have. Although many investors gravitate toward net income, operating cash flow is a better metric of a company's financial health for two main reasons. First, cash flow is harder to manipulate under GAAP than net income (although it can be done to a certain degree). Second, "cash is king" and a company that does not generate cash over the long term is on its deathbed.

But operating cash flow doesn't mean EBITDA (earnings before interest taxes depreciation and amortization). While EBITDA is sometimes called "cash flow", it is really earnings before the effects of financing and capital investment decisions. It does not capture the changes in working capital (inventories, receivables, etc.). The real operating cash flow is the number derived in the statement of cash flows.

Overview of the Statement of Cash Flows
The statement of cash flows for non-financial companies consists of three main parts:
Operating flows - The net cash generated from operations (net income and changes in working capital).
Investing flows - The net result of capital expenditures, investments, acquisitions, etc.
Financing flows - The net result of raising cash to fund the other flows or repaying debt.
By taking net income and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, inventories) and other current accounts, the operating cash flow section shows how cash was generated during the period. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important.

Accrual Accounting vs. Cash Flows
The key differences between accrual accounting and real cash flow are demonstrated by the concept of the cash cycle. A company's cash cycle is the process that converts sales (based upon accrual accounting) into cash as follows:
Cash is used to make inventory.
Inventory is sold and converted into accounts receivables (because customers are given 30 days to pay).
Cash is received when the customer pays (which also reduces receivables).
There are many ways that cash from legitimate sales can get trapped on the balance sheet. The two most common are for customers to delay payment (resulting in a build up of receivables) and for inventory levels to rise because the product is not selling or is being returned.

For example, a company may legitimately record a $1 million sale but, because that sale allowed the customer to pay within 30 days, the $1 million in sales does not mean the company made $1 million cash. If the payment date occurs after the close of the end of the quarter, accrued earnings will be greater than operating cash flow because the $1 million is still in accounts receivable.

Harder to Fudge Operating Cash Flows
Not only can accrual accounting give a rather provisional report of a company's profitability, but under GAAP it allows management a range of choices to record transactions. While this flexibility is necessary, it also allows for earnings manipulation. Because managers will generally book business in a way that will help them earn their bonus, it is usually safe to assume that the income statement will overstate profits.

An example of income manipulation is called "stuffing the channel" To increase their sales, a company can provide retailers with incentives such as extended terms or a promise to take back the inventory if it is not sold. Inventories will then move into the distribution channel and sales will be booked. Accrued earnings will increase, but cash may actually never be received, because the inventory may be returned by the customer. While this may increase sales in one quarter, it is a short-term exaggeration and ultimately "steals" sales from the following periods (as inventories are sent back). (Note: While liberal return policies, such as consignment sales, are not allowed to be recorded as sales, companies have been known to do so quite frequently during a market bubble.)

The operating cash flow statement will catch these gimmicks. When operating cash flow is less than net income, there is something wrong with the cash cycle. In extreme cases, a company could have consecutive quarters of negative operating cash flow and, in accordance with GAAP, legitimately report positive EPS. In this situation, investors should determine the source of the cash hemorrhage (inventories, receivables, etc.) and whether this situation is a short-term issue or long-term problem. (For more on cash flow manipulation, see Cash Flow On Steroids: Why Companies Cheat.)


Cash Exaggerations
While the operating cash flow statement is more difficult to manipulate, there are ways for companies to temporarily boost cash flows. Some of the more common techniques include: delaying payment to suppliers (extending payables); selling securities; and reversing charges made in prior quarters (such as restructuring reserves).

Some view the selling of receivables for cash - usually at a discount - as a way for companies to manipulate cash flows. In some cases, this action may be a cash flow manipulation; but I think it is also a legitimate financing strategy. The challenge is being able to determine management's intent.

Cash Is King
A company can only live by EPS alone for a limited time. Eventually, it will need cash to pay the piper, suppliers and, most importantly, the bankers. There are many examples of once-respected companies who went bankrupt because they could not generate enough cash. Strangely, despite all this evidence, investors are consistently hypnotized by EPS and market momentum and ignore the warning signs.


The Bottom Line
Investors can avoid a lot of bad investments if they analyze a company's operating cash flow. It's not hard to do, but you'll need to do it, because the talking heads and analysts are all too often focused on EPS.
by Rick Wayman


Read more: http://www.investopedia.com/articles/analyst/03/122203.asp#ixzz1hVjope5c

Working Capital (Cash Conversion Cycle)

http://www.qfinance.com/cash-flow-management-best-practice/how-to-better-manage-your-financial-supply-chain?full

Understanding The Cash Conversion Cycle

by Jim Mueller (Contact Author | Biography)

The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower this number is, the better for the company. Although it should be combined with other metrics (such as return on equity and return on assets) it can be especially useful for comparing close competitors because the company with the lowest CCC is often the one with better management. In this article, we'll explain how CCC works and show you how to use it to evaluate potential investments. 

What Is It?
The CCC is a combination of several activity ratios involving accounts receivable, accounts payable and inventory turnover. AR and inventory are short-term assets, while AP is aliability; all of these ratios are found on the balance sheet. In essence, the ratios indicate how efficiently management is using short-term assets and liabilities to generate cash. This allows an investor to gauge the overall health of the company. (For further reading, see Reading The Balance Sheet andIntroduction To Fundamental Analysis: The Balance Sheet.)

How do these ratios relate to business? If the company sells what people want to buy, cash cycles through the business quickly. If management cannot figure out what sells, the CCC slows down. For instance, if too muchinventory builds up, cash is tied up in goods that cannot be sold - this is not good news for the company. In order to move out this inventory quickly, management might have to slash prices, possibly selling its product at a loss. If AR is handled poorly, it means that the company is having difficulty collecting payment from customers. This is because AR is essentially a loan to the customer, so the company loses out whenever customers delay payment. The longer a company has to wait to be paid, the longer that money is unavailable for investment elsewhere. On the other hand, the company benefits by slowing down payment of AP to its suppliers, because that allows the company to make use of the money for longer. (To learn more, read Measuring Company Efficiency and Understanding The Time Value Of Money.) 




The Calculation
To calculate CCC, you need several items from the financial statements:

• Revenue and cost of goods sold (COGS) from the income statement
• Inventory at the beginning and end of the time period
• AR at the beginning and end of the time period
• AP at the beginning and end of the time period
• The number of days in the period (year = 365 days, quarter = 90)

Inventory, AR and AP are found on two different balance sheets. If the period is a quarter, then use the balance sheets for the quarter in question and the ones from the preceding period. For a period of a year, use the balance sheets for the quarter (or year end) in question and the one from the same quarter a year earlier.

This is because, while the income statement covers everything that happened over a certain period of time, balance sheets are only snapshots of what the company was like at a particular moment in time. For things like AP, you want an average over the period of time you are investigating, which means that AP from both the time period's end and beginning are needed for the calculation.

Now that you have some background on what goes into calculating CCC, let's take a look at the formula:

CCC = DIO + DSO - DPO

Let's look at each component and how it relates to the business activities discussed above.Days Inventory Outstanding (DIO): This addresses the question of how many days it takes to sell the entire inventory. The smaller this number is, the better.

DIO = Average inventory/COGS per day Average Inventory = (beginning inventory + ending inventory)/2

Days Sales Outstanding (DSO): This looks at the number of days needed to collect on sales and involves AR. While cash-only sales have a DSO of zero, people do use credit extended by the company, so this number is going to be positive. Again, smaller is better.

DSO = Average AR / Revenue per day Average AR= (beginning AR + ending AR)/2

Days Payable Outstanding (DPO): This involves the company's payment of its own bills or AP. If this can be maximized, the company holds onto cash longer, maximizing its investment potential; therefore, a longer DPO is better.

DPO = Average AP / COGS per day Average AP = (beginning AP + ending AP)/2

Notice that DIO, DSO and DPO are all paired with the appropriate term from the income statement, either revenue or COGS. Inventory and AP are paired with COGS, while AR is paired with revenue.Practical ApplicationLet's use some real numbers from a retailer as an example to work through. The data below is from Barnes & Noble's 10-K reports filed for the fiscal years ending January 28, 2006 (fiscal year 2005) and January 29, 2005 (fiscal year 2004). All numbers are in millions of dollars.

Item	Fiscal Year 2005	Fiscal Year 2004
Revenue	5103.0	Not needed
COGS	3533.0	Not needed
Inventory	1314.0	1274.6
A/R	99.1	91.5
A/P	828.8	745.1
Average Inventory	( 1314.0 + 1274.6 ) / 2 = 1294.3
Average AR	( 99.1 + 91.5 ) / 2 = 95.3
Average AP	( 828.8 + 745.1 ) / 2 = 787.0

Now, using the above formulas, CCC is calculated:

DIO = $1294.3 / ($3533.0 / 365 days) = 133.7 days DSO = $95.3 / ($5103.0 / 365 days) = 6.8 days DPO = $787.0 / ($3533.0 / 365 days) = 81.3 days CCC = 133.7 + 6.8 - 81.3 = 59.2 days

What Now?
As a stand alone number, CCC doesn't mean very much. Instead, it should be used to track a company over time and to compare the company to its competitors.

When tracking over time, determine CCC over several years and look for an improvement or worsening of the value. For instance, for fiscal year 2004, Barnes & Noble's CCC was 68.9 days, so the company has shown an improvement between the ends of fiscal year 2004 and fiscal year 2005. Barnes & Noble achieved this improvement by decreasing DIO by 4.5 days, increasing DSO by 1.5 days and increasing DPO by 6.7 days. While between these two years the change is good, the slight increase in DSO might merit more investigation, such as looking further back in time. CCC changes should be examined over several years to get the best sense of how things are changing.

CCC should also be calculated for the same time periods for the company's competitors, such as Borders Group and Amazon.com. For fiscal year 2005, Borders' CCC was 101.2 days (168.4 + 12.0 - 79.2). Compared to Borders Group, Barnes & Noble is doing a better job at moving inventory (lower DIO), is quicker at collecting what it is owed (lower DSO) and keeps its own money a bit longer (higher DPO). Remember, however, that CCC should not be the only metric used to evaluate either the company or the management; return on equityand return on assets are also valuable tools for determining the effectiveness of management. (For more insight, check out Keep Your Eyes On The ROE, Understanding The Subtleties Of ROA Vs. ROE and ROA On The Way.) 

Interestingly, Amazon's CCC for the same period is negative,coming in at -31.2 days (29.6 + 10.2 - 71). This means that Amazon doesn't pay its suppliers for the books that it buys until after it receives payment for selling those books; therefore, Amazon doesn't have a need to hold very much inventory and still hold onto its money for a longer period of time. Although online retailers have this advantage, there are other issues that keep Borders and Barnes & Noble in the game. After all, you cannot curl up in those comfortable chairs with a fresh latte at Amazon - despite Amazon's success, there is still something to be said for the experience of going to a bookstore.




Wrapping It Up
The cash conversion cycle is one of several tools that can help you evaluate management, especially if it is calculated for several consecutive time periods and for several competitors. Decreasing or steady CCCs are good, while rising ones should motivate you to dig a bit deeper.

CCC is most effective with retail-type companies, which have inventories that are sold to customers. Consulting businesses, software companies and insurance companies are all examples of companies for whom this metric is meaningless. 

For additional reading, see Using The Cash Conversion Cycle and Cash 22: Is It Bad To Have Too Much Of A Good Thing? 

by Jim Mueller (Contact Author | Biography)
Jim Mueller started his career as a scientist, earning his advanced degree in biochemistry and molecular biology from Washington State University. He has since become a self-taught investor and financial writer. He is also a regular contributor to The Motley Fool.

http://www.investopedia.com/articles/06/cashconversioncycle.asp

Also read:
Cash Conversion Cycle
http://en.wikipedia.org/wiki/Cash_conversion_cycle

Measure the cash operating cycle

Let us examine the method used to measure the length of the cash operating cycle.  This is used to assess a business's cash needs and any financing requirement.

Measuring the cycle

The following formulae can be used to measure the length of the cash operating cycle for a manufacturing business.  The length is usually measured in days, although weeks or months can easily be calculated too.

a.  Raw materials holding period
= (average raw materials inventory / annual raw material usage) x 365 days

b.  Materials conversion period
= (average work in progress inventory / annual cost of sales) x 365 days

c.  Finished goods inventory period 
= (average finished goods inventory / annual cost of sales) x 365 days

d.  Receivables collection period
= (average receivables / annual sales) x 365 days

e.  Supplier's payment period
= (average trade payables / annual purchases) x 365 days

Length of Cash operating cycle length 
= a + b + c + d - e

The following should also be considered:

• Business growth, which will affect the cycle in the future, and 
• Seasonality, which will affect the cycle at different times of the year.

---

Think about the cash operating cycle of your business in comparison with that of your suppliers and customers.  

• Who has the greatest exposure to cash flow problems?
• How much room to manouevre do you have if your cycle slows down?
• Do you need extra finance?

---

Financing the cycle

The length of the working capital cycle will help indicate how much working capital is required by the business and therefore how much needs to be financed.  For most businesses there will be a proportion of their working capital requirement which is constant and a proportion which is variable.

• It is advisable to fund the constant stable part with medium to long-term finance.  
• For the variable requirement, short-term flexible finance such as an overdraft is more suitable.

The value of investment required will increase over the cycle.  For example, 

• a business with 20 inventory days and 80 receivable days cannot be compared to 
• a business with 80 inventory days and 20 receivable days.  

Although both have 100 days' requirement, the investment required in the first business is far higher, as the value of receivables (sales price) is more than the value of inventory (cost).

The cash operating cycle length should be measured to determine the working capital financing requirements.

Understand the Cash Operating Cycle

The cash operating cycle is the length of time between paying out cash for inputs and receiving cash from sales.  It is also referred to as the working capital cycle or  cash conversion cycle.

Businesses should understand, measure, control and finance their cash operating cycle.  It is also useful to be aware of the cash operating cycles of  customers, suppliers and even competitors.  The cash operating cycle is normally measured in days and is represented by the diagram below, using the example of a manufacturer.

---

Time ------------------------->

Inventory of raw materials ---> @Cash paid out --> Conversion of raw materials --->  Inventory of finished materials ---> Receivables collection period ---> #Cash received

Supplier's payment period ---@Cash paid out --- CASH OPERATING CYCLE --- # Cash received

---

Service Businesses
A consultancy working on long-term projects may have lots of money owed to them for 'unbilled work-in-progress' as well as long receivable collection periods.  Their main input cost will be consultants, who have no payment period.  A small consultancy business may have difficulty financing long cash operating cycles.  As such, it is common practice for consultancies to ask for stage payments from their clients on a long project.

Seasonal Businesses
Seasonal businesses, such as calendar and diary manufacturers have fluctuating operating cycles.  Production is spread throughout the year and inventories will gradually build up.  Trade receivables will increase from a low start as retailers stock up for the peak sales season, but may not pay until after the season.  The supplier's payment period will be negligible and therefore seasonal manufacturers will require several months of financing.

Retailers
A large retailer such as a supermarket will have a relatively low finished goods inventory period (due to perishables) and minimal receivables as the majority of their sales are in cash.  In addition, due to their size and purchasing power they can negotiate extended payment terms with suppliers.  Therefore, some supermarkets will actually have a negative cash operating cycle, in that they receive cash from customers before they have to pay suppliers.

The Ideal Cycle
Businesses should aim to minimize their cash operating cycles.

Know and try to minimize your cash operating cycle.

Investing in Retail: Understanding the Cash Conversion Cycle

Investing in Retail: Understanding the Cash Conversion Cycle

One of the best ways to distinguish excellent retailers from average or below average ones is to look at their cash conversion cycles. The cash cycle tells us how quickly a firm sells its goods (inventory), how fast it collects payments from customers for the goods (receivables), and how long it can hold on to the goods itself before it has to pay suppliers (payables).

Figure: The cash conversion cycle

= Days in Inventory + Days in Receivables - Days Payable Outstanding

= 365/Inventory turnover + 365/Receivables turnover - 365/Payables turnover

Where,
Inventory turnover = Cost of goods sold/Inventory
Receivables turnover = Sales/Accounts receivable
Payables turnover = Cost of goods sold/Accounts payable

Naturally, a retailer wants to sell its products as fast as possible (high inventory turns), collect payments from customers as fast as possible (high receivables turns), but pay suppliers as slowly as possible (low payables turns).

The best-case scenario for a retailer is to sell its goods and collect from customers before it even has to pay the supplier. Wal-Mart is one of the best in the business at this: 70 percent of its sales are rung up and paid for before the firm even pays its suppliers.

Looking at the components of a retailer's cash cycle tells us a great deal. A retailer with increasing days in inventory (and decreasing inventory turns) is likely stocking its shelves with merchandise that is out of favor. This leads to excess inventory, clearance sales, and, eventually, declining sales and stock prices.

Days in receivables is the least important part of the cash conversion cycle for retailers because most stores either collect cah directly from customers at the time of the sale or sell off their credit card receivables to banks and other finance companies for a price. Retailers don't really control this part of the cycle too much.

However, some stores, such as Sears and Target, have brought attention to the receivables line because they've opted to offer customers credit and manage the receivables themselves. The credit card business is a profitable way to make a buck, but it's also very complicated, and it's a completely different business from retail. We're wary of retailers that try to boost profits by taking on risk in their credit card business because it's generally not something they're very good at.

If days in inventory and days in receivables illusrate how well a retailer interacts with customers, days payable outstanding shows how well a retailer negotiates with suppliers. It's also a great gauge for the strength of a retailer.

Wide-moat retailers such as Wal-Mart, Home Depot, and Walgreen optimize credit terms with suppliers because they're one of the few (if not the only) games in town. For example, 17 percent of P&G's 2002 sales came from Wal-Mart. The fortunes of many consumer product firms depend on sales to Wal-Mart, so the king of retai has a huge advantage when ordering inventory: It can push for low prices and extended payment terms.

Home Depot finally started taking advantage of its competitive position by squeezing suppliers in 2001 and 2002. Days payable outsanding for the home improvement titan has historicaly been around 25. In 2001, the figure hit 33 days, and by 2002, it exceeded 40 days. By holding on to its cash longer and reducing short-term borrowing needs, Home Depot increased its operating cash flow from an average of $2.4 billion from 1998 to 2000 to $5.6 billion from 2002 to 2003.