A powerful way to frame the financing consequences of working capital is to frame working capital temporally rather than monetarily. This framing is called the cash conversion cycle.
To see the cash conversion cycle in action, imagine that you run a hardware store and all that you do is buy hammers from wholesalers and sell them to home improvement professionals. Several transactions are associated with a single hammer, and they don’t happen at the same time. You have to buy the hammer, pay for it, sell it, and collect the cash for that sale. Let’s say you sell the hammer seventy days after you bought it, and you don’t get paid until forty days after the sale. Those figures correspond to a days inventory of seventy days and a receivables collection period of forty days. From a business perspective, this means that 110 days elapse from the time you buy a hammer to getting cash for it. In addition, you didn’t pay cash for that hammer until thirty days after buying it.
From a cash perspective, you need to generate cash to pay for the hammer eighty days before receiving the cash.
If companies pay before getting paid, they must finance the shortfalls in their cash conversion cycles. None of this shows up in the measure of net profit or EBITDA. So just buying and selling hammers creates a financing need.
Equation:
CCC=DIO+DSO−DPO
where:
DIO= Days of inventory outstanding (also known as days sales of inventory)
DSO= Days sales outstanding
DPO= Days payables outstanding
The gap in the cash conversion cycle raises several questions. How much is this gap going to cost to finance? How can the company change behaviors to reduce those costs? Will those changes cost more than the savings?
Let’s return to the hardware store. A supplier encourages you to pay within ten days by offering a 2 percent discount—a fairly typical offer. Is that a good deal?
