Monday, 24 May 2010

Analyzing Cash Flows

Cash is the oxygen that keeps a business alive. Even a profitable business can die if its cash availability is inadequate to meet emerging commitments such as payments to creditors, interest payments on borrowings and loan repayments. The creditors can go to court and force a business to sell its facilities and pay their dues.

How can a profitable business become short of cash? The answer is that it can run out of cash in several ways. For example, it might be trying to expand its business too fast by extending liberal credit to attract more customers, and stocking up on materials and merchandise to ensure that orders, however small, are not lost on "out-of-stock" grounds.

Inventories need to be sold and then the credit period has to be waited out before actual cash is received. If this period is considerably more than the period of credit it receives from its own suppliers, a business can easily find itself out of cash to pay the suppliers.

It is this aspect of operations that the Cash Conversion Cycle (CCC) seeks to measure. CCC is computed by adding the number of days' sales (or better, Cost of Sales) in inventory (DIO) to the number of days' sales in receivables (DSO), and then deducting the number of days' sales (or Cost of Sales) in Payables (DPO) from the total.


Computing the Cash Conversion Cycle

We need the following five values to compute the CCC:

  • Revenue or Sales
  • Cost of Sales
  • Average Inventory during the period
  • Average Receivables during the period
  • Average Payables during the period

Of these, sales and cost of sales are obtained from the Income Statement while the remaining values are from the Balance Sheet. Average values of inventory, receivables and payables are computed by totaling the opening and closing values of each and dividing by two.

Let us do the computations using the following values extracted from a published annual report:

  • Revenues: 1395832
  • Cost of Sales: 1673403
  • Average Receivables - (closing + opening)/2, i.e. (501212 + 679378) / 2 = 590295
  • Average Inventory (552074 + 1958233) / 2 = 1255153.5
  • Average Payables (1641457 + 2255022) / 2 = 1848240

Dividing the yearly revenue by 365 we get a day's sales: 1395832 / 365 = 3824.20. Day's cost of sales is also computed similarly: 1673403 / 365 = 4584.67.

The receivables of 590295 represent 590295 / 3824.20 = 154.36 days' sales, i.e. 5 months' sales. Inventory of 1255153.5 represents 1255153.5 / 1673403 = 258.55 days' cost of sales, i.e. nearly 9 months' sales. In total, 412.91 days', i.e. more than a years' worth of sales are blocked in receivables and inventories (both of which have been brought down by the year end).

As against this, the company enjoyed 1848240 / 4854.67 = 380.71 days' cost of sales worth of credit, i.e. more than one year's credit.

The company's Cash Conversion Cycle thus works out to: 154.36 + 258.55 - 380.71 = 32.2 days. Even this was possible only because of the high credit given to the company by its creditors.

While the cash conversion cycle measures what happened in the past, it is the future-oriented cash budgeting exercise that helps a business control its cash position. Cash budgeting can forecast likely cash shortages so that the company can arrange funds to meet these.

We will look at cash budgeting in the next post.


  1. Nice post. Cash Flow means accounting statement called the "statement of cash flows", which shows the amount of cash generated and used by a company in a given period. It is calculated by adding noncash charges (such as depreciation) to net income after taxes. Cash flow can be attributed to a specific project, or to a business as a whole. Cash flow can be used as an indication of a company's financial strength.

    life contingent structured settlement

  2. Nice post and useful information given on cash flows..thanks for posting!!

    motilal oswal online trading