Preface: The cash conversion cycle to accrual method accounting is like photosynthesis, its happens every day but only few take the time to consider the importance of the process and the intricate implications. If your business is managed starboard, you can appreciate that reality that calm weather is more agreeable, i.e. satisfactory levels of working capital lead calm business management.
Working Capital Tools for Successful Business Performance
Credit: Donald J. Sauder, CPA, CVA
Liquidity measurements in an accounting equation calculate the ability of a business to pay and satisfy current period cash uses with assets that are easily convertible into cash, e.g. current assets. Liquidity measurements speak to the traction of liquidity, i.e. pace of collections of account receivables, inventory turns and inertia of liquidity, paying accounts payable or term loans to rapidly. In addition, fluctuations in line of credit from lack of operating cash can also lead liquidity volatility.
Strategy-Business.com journalist Matt Palmquist wrote an interesting article on working capital balances vs. shareholder value; excerpt-
“… the importance that companies attach to having plenty of working capital on hand, the firms in the study put an average of more than 27 percent of their total assets into net operating capital—a rather substantial amount. But the stock market’s reaction to the building up of strategic reserves was somewhat less substantial, the authors found.
For the average firm, every additional dollar converted into net operating capital was valued by shareholders at only 52 cents. Not only is this number obviously much less than the actual value of the amount being invested, but it’s also far below the US$1.49 valuation that shareholders place on any additional dollar held in cash or liquid securities”.
Certainly research supports that working capital doesn’t leverage business value, but it is like an insurance policy, if you don’t need it, you don’t need it. And If you do….?
Buoyed With Optimized Liquidity
Improvements in liquidity for entrepreneurs begin with increasing cash and cash equivalents, obtaining term loans, or line of credit increases for additional operating capital, i.e. finance inventory or accounts receivable increases, or reducing the cash conversion cycle, i.e. gaining traction on liquidity.
The cash conversion cycle calculates the amount of cash necessary to finance inventory and accounts receivables and keep accounts payable balance normalized. The cash conversion cycle is calculated with the formula of 1) number of days’ inventory is outstanding; plus, 2) number of days’ receivables are outstanding; minus, 3) number of days’ payable are outstanding.
Tracking the cash conversion cycle for one period is relatively uninformative; but tracking consecutive periods and changes in each consecutive segment, i.e. 60 to 50 days of inventory outstanding, 30 to 25 days of accounts receivable outstanding, and 20 to 22 days of accounts payable outstanding, will measure the cash conversion cycle analytics change from a metric of 110 to 97. Changes in the formula monitored consecutively period to period, will provide helpful analytical detail of the cash levels and when compared to competitors will offer visual insights into a business measurement of optimized accrual accounting working capital levels necessary for period cash inflows and cash outflows. This effort increases the likelihood of realistic financial projection on cash flows too.
With changes in a cash conversion cycle when adjusting from check payments to credit card receivable, the collection times of cash are markedly improved. Managing inventory dimples with reductions of obsolete or slow moving merchandise, as an analytical approach to cash, can usually free up more liquid cash to satisfy immediate debt obligations, or finance other short-term liquidity obligations.
The cash conversion cycle to accrual method accounting is like photosynthesis, its happens every day but only few take the time to consider the importance of the process and the intricate implications. The larger the business the more analytically valuable the financial measurements provided by an expert i.e. a chief financial officer (CFO), or accountant (CPA).