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Concept of cash conversion cycle with example - Apohan Corporate Consultants Pvt. Ltd.

Concept of cash conversion cycle with example

Apohan Corporate Consultants Pvt. Ltd. > Financial Strategy > Concept of cash conversion cycle with example

Importance of operational performance

A business is basically a business and not a bank. Whatever financial benefits come to a business on account of some favourable development on financial front can complement the operational profit but cannot in themselves lead/save the company and make a financial sense. Hence, operating profit (meeting marketing costs and operating expenses) should be taken as the very serious performance parameter by a business. Operational surplus is the real wealth of a company. Even if there is marginal operating profit, the company can be revived after financial restructuring. A company should analyse trends in the profitability ratios at various levels and the corrective measures should be undertaken if there is a negative trend.

 


Importance of cash conversion cycle

For a given fixed setup, for a given fixed working capital, and provided that there is sufficient demand at attractive price, there is a natural limit on the maximum sales a business can make. If we assume, for a moment, that there is no way to increase this capital, are we going to treat this as the limit of our growth? No! We can make it into more virtual capital by rotating it faster, or, you can say, for more number of times in the same period. If we assume that our profit margins are same, the faster we rotate the capital, the more number of times we get the profits on it. There are contributors with fixed expectations (such as the bank loan) of return on the capital. Hence, the excess generated accrues to the equity shareholders. See the example below of cash conversion cycle

Day 0 = you invest rupees 100 for other running expenses
Day 1 = you receive all raw materials of 200
Day 8 = you receive supplier invoice
Day 10 = you start processing raw materials
Day 15 = bank provides rupees 150 for other running expenses
Day 30 = you complete the manufacturing process
Day 40 = your client receives the finished goods
Day 50 = you Raise client invoice
Day 70 = you receive additional 200 rupees to settle the supplier from bank
Day 110 = you received client payment of Rs. 470
Day 120 = you pay the bank 350 rupees and interest
Day 121 = You invest the new balance in the new cycle

Interest = 150*(120-10)/30*1% + 200*(120-70)/30*1% = 8.83
Day 121 = you invest 470-350-8.83 = Rs. 111 for next order.
You can do this = 360/120 = 3 times in a year.
If you presume the same efficiency, the amount at the end of year is = 100* (1.11)^3 = 137
Now the applications of the company to others the long-term lenders annually fixed. Latest assume that this application is rupees 21 per annum for a long-term loan of Rs. 300.
So so you have made = 137-21 = 16.
Latest resume that your own long-term capital investment at the beginning of the Year (equity and Reserves, and not as the market price of the share) is Rs. 350. The amount of rupees 100 that you invested as working capital also is permanently locked. So you have made return of = 16 /(350+100) = 3.33% on all your capital annually.
By Indian standards, this is very poor return and even comparable to the bank loans. Let’s see what happens if we increase the number of cash conversion cycles:
4 cycles, Return = 6.67%
8 Cycles, Return = 19.90%
Now, the speed of the operations cannot be increased without some additional capital investment. But even if we consider the payment for that capital, return off around 3.33% can be in increased to around 16% by working on the cash conversion cycle. What the measurement of cash conversion parameters is not easy as there are hundreds of parameters.

 


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