What is the Cash Conversion Cycle?
The cash conversion cycle is a resource used in management accounting to measure a firm's cash reserves in a time variable. This equation is used when the entity decides to increase operations and production costs. he cash conversion cycle is used when companies or business enterprises look to expand their customer sales position—increased resources leads to increased production, which leads to increased sales. In essence, the cash conversion cycle is a measure of the liquidity risk entailed by growth—increased production is obviously met with increased costs.
Definition of the Cash Conversion Cycle:
The cash conversion cycle equals the number of days between disbursing cash and collecting cash in connection with the company undertaking a discrete unit of operations. The term “cash conversion cycle” refers to the timespan between the firm paying-out monies for resources (including employee wages) and collecting cash from the sale of products. That being said, the cash conversion cycle cannot be direct observed in the firm’s cash flows; the raw cash flow will be influenced by variables not entertained by the cash conversion cycle, such as various investment and financing activities.
The cash conversion cycle is typically applied to a retailer. Because a retailer's business model consists of buying and selling inventory, the cash conversion cycle will analyze the time between the following two business maneuvers:
1.) dispersing cash to accounts payable and 2.) acquiring cash to satisfy the accounts receivable
Furthermore, the cash conversion cycle is utilized to accommodate a firm that buys and sells on an account basis. For a cash-only business model, the equation would only need data from the sales operation, because the dispersing of cash would be a direct measure as a purchase of inventory and collecting cash would be directly measurable as a sale of inventory. That being said, a one to one correspondence does not exist for a firm that buys and sells on account; fluctuations in cash will be terminate these accounting methods. As a result, the cash conversion cycle is calculated by computing a change in cash through the effect on the receivables, payables, and inventory and before tabulating back to cash.