An often-overlooked ratio to track is a combination of three other ratios…
Once you calculate the other three you simply add the three to get this Turbo Ratio that I recommend all businesses with accounts receivable and inventory track.
So, what is it called?
It is called…
Your Cash Conversion Cycle
It is the measurement of how many days on average it is taking your company to convert sales into cash.
It is the combination of three separate ratios:
- Days Receivable – the number of days on average it takes to collect your accounts receivable.
- Days Inventory – the number of days on average it takes to sell your inventory.
- Days Payable – the number of days on average you take to pay your bills.
Let us go through each of these three ratios…
Your Days Receivable
Here the lower the number of days the faster you are converting your receivables in cash.
You need the following numbers to calculate your days receivable ratio:
- Opening balance of your accounts receivable, at the beginning of the month
- Closing balance of your accounts receivable at the end of the month
- Your monthly sales on credit (non-cash sales)
Add your opening accounts receivable balance to your closing accounts receivable balance and divide by 2.
Take that number and divide by your total credit sales for the month.
Multiply that number by the number of days in the month.
Accounts receivable opening balance = $100,000
Accounts receivable closing balance = $200,000
Average accounts receivable balance = ($100,000 + $200,000)/2 = $150,000
Sales for the month = $300,000
Days in the month = 30
$150,000/$300,000 x 30 = 15 days
Now let us look at the next ratio…
Your Days Inventory
Here as well, a lower number of days is better for your cash-flow.
You need the following numbers to calculate your Days Inventory ratio:
- Opening balance of your inventory, at the beginning of the month
- Closing balance of your inventory, at the end of the month
- Your Cost of Goods Sold for the month.
Add your opening inventory balance to your closing inventory balance and divide by 2.
Take that number and divide by your total Cost of Goods Sold for the month.
Multiply that number by the number of days in the month.
Inventory opening balance = $300,000
Inventory closing balance = $600,000
Average inventory balance = ($300,000 + $600,000)/2 = $450,000
Cost of Goods Sold for the month = $750,000
Days in the month = 30
$450,000/$750,000 x 30 = 18 days
On average it is taking you 18 days to turn your inventory over. In other words, to sell it.
Now let us look at the next ratio…
Your Days Payable
For this ratio, a higher number is better! Why? Because you are taking longer (i.e. more days) to pay your bills on average which means you are preserving cash for a longer period.
You need the following numbers to calculate your days payable ratio:
- Opening balance of your accounts payable, at the beginning of the month
- Closing balance of your accounts payable at the end of the month
- Your monthly Cost of Goods Sold
Add your opening accounts payable balance to your closing accounts payable balance and divide by 2.
Take that number and divide by your total Cost of Goods Sold for the month.
Multiply that number by the number of days in the month.
Accounts payable opening balance = $250,000
Accounts payable closing balance = $350,000
Average accounts payable balance = ($250,000 + $350,000)/2 = $300,000
Cost of goods sold for the month = $900,000
Days in the month = 10
$300,000/$900,000 x 30 = 10 days
Now, let us put it al together…
Your Cash Conversion Cycle
The formula for your cash conversion cycle is:
- Days receivable
- Days inventory
- Less – Days payable
Using our numbers from above we have:
Days receivable = 15 days
Days inventory = 18 days
Days payable = 10 days
Your Cash Conversion Cycle is 15 plus18 minus 10=23 days
Although this is a very crude measurement what it tells you is that on average you will convert your sales into cash in about 23 days.
In Closing
Remember the lower the number the better. Why? Intuitively you will want to convert accounts receivable and inventory to cash as quickly as possible. Less days to do so means cash is hitting your bank account more rapidly.
One other thing to keep in mind is that the Days payable number is more beneficial the higher it is! That is why it is subtracted in the Cash Conversion Cycle Formula.
The longer you take to pay your bills the more cash you have available to run your business. Here you will want to operate with integrity and not take too long to pay your suppliers. After all, they are essentially your partners in your business.
That said, it is fair if you take advantage of longer payment terms and wait as long as possible to pay.
Thank you for reading….