Page
Strategies for Managing the Cash Conversion Cycle
Completion requirements
View
One of the strategies in managing the Cash Conversion Cycle is to increase the stock turnover ratio.
The lower the inventory levels, the higher the stock turnover ratio. Inventory levels can be lowered by:
- Removing all redundant and obsolete stock.
- Effective stock ordering systems, e.g. EOQ or JIT.
- Reducing ageing stock, e.g. organising special promotions.
- Buying materials of the right quality.
In keeping stock turnover as high as possible, caution should be taken to avoid stock out situations, which might lead to loss of sales.
Decrease Debtors Collection Period
Debtors are the result of sales that have taken place on credit. Companies may be forced to give credit because of competition or to land contracts with big clients (e.g. Pick n Pay).
Debtors can be encouraged to pay sooner by:
- Giving early settlement discounts.
- Imposing stricter debt collection procedures, e.g. reminders, summonses, etc.
- Charging interest on overdue accounts.
Again, caution should be taken not to lose sales due to high-pressure collection techniques.
Increase Creditors Payment Period
Creditors are the result of purchases that take place on credit. This type of financing is also known as spontaneous financing and can be interest-bearing or interest-free. Terms are usually between one and three months and can be secured or unsecured.
Basically, a company should use all the interest-free, unsecured financing available to it, over the longest term possible.
In theory, extending creditors payment period seems a simple solution to the problem (the cheque is in the mail!). These are, at best, short-term solutions, since strategies of this kind can sour relationships with suppliers and result in credit facilities being suspended. Attractive settlement discounts are also lost by paying late.
Cost Implication
Every day that a company must wait for its cash to return (as indicated by the CCC), are funds that could have been used elsewhere. If a long CCC causes the company to use overdraft facilities, interest will have to be paid on the required funds.
The following formula is a rough but effective way of demonstrating the cost of a positive CCC:
Annual cost = Average inventory x overdraft rate
Daily cost = Annual cost ÷ 365
Total cost = Daily cost x CCC
Example:
Assume the following figures for Cash Strapped (Pty) Ltd:
Average inventory: 200 000
Stock turnover in days: 90 days
Debtor’s collection period: 90 days
Creditor’s payment period: 30 days
Overdraft interest rate: 22%
Therefore, CCC equals (90 + 90) – 30 = 150 days
Annual cost of CCC equals 200 000 x .22 = R44 000
Daily cost of CCC equals 44 000 – 365 = R121
Total cost of CCC equals R121 x 150 = R18 150