The fundamental quality of an investment opportunity is a function of that particular company’s ability to convert inventory into cash more efficiently than its competitors. This capacity for generating cash from sales represents a factor known as the Cash Conversion Cycle of the organization. By understanding how to calculate and manipulate the cash conversion cycle of an investment opportunity, a personal investor can improve their investment portfolio by choosing only those companies that are either already operating efficiently, or facing an opportunity to profit from an improvement in their processes.
The cash conversion cycle is calculated as being the sum of a company’s Days Inventory Outstanding and Days Receivables Outstanding ratios, less the Days Payable Outstanding ratios. Each of these ratios can be calculated using the balance sheet and income statement, and represents the amount of time that each of these factors has been outstanding for.
For example, the days inventory outstanding ratio represents the average number of days out of the year that a given unit of inventory will spend in storage before it is sold. Alternatively, the receivables and payables equivalent metrics show us how long that a given trade-debt (either from or to the company) will be outstanding before it is paid out. The combination of all of these metrics then represents the ability of the company to turn a sale into cash, along with the net benefit that it realizes from delaying payments to suppliers through its accounts payables.
When initially calculating the cash conversion cycle, it is important to remember how it is that different accounting practices can dramatically impact the metric, and therefore hide the actual results that the company is achieving. Specifically, because of the way in which different companies will use different accounting standards to record their inventory and Costs of Goods Sold levels, it is important to remember to adjust the financial statements to reflect the same accounting standards.
This is generally accomplished by ensuring that both statements follow First-In-First-Out practice, as opposed to Last-In-Last-Out practices. Not sure what this means? No problem, just remember to add the “LIFO Reserve” on the balance sheet back into the inventory balance and you’ll be on the right track.
