Having looked at how we can standardize and calculate a company’s ability to convert its inventory into cash through the cash conversion cycle metric, we can now go into detail about the nuances of interpreting how it is that we would use this metric to gain insights into the opportunities and risks of a given investment. Specifically, we want to be able to determine how efficient a given company is compared to its peers, and whether or not there is an opportunity to create value for shareholders by improving this metric.
Once we have calculated the cash conversion cycle metric, we have found out how many days it takes for a company to turn a given unit of inventory into cash, with adjustments made for the amount of time it takes for the company to pay its suppliers, and to receive funds from its customers/distributors.
The first step to interpreting this metric is to then compare it to the industry standard metrics, so that we know how it is that this particular company compares to its peers. If we are seeing that the metric is above its peers, we know that the company is moving a bit more slowly than its peers, and might be comparatively inefficient. Alternative, if the metric is lower than its peers, it might be that the company is moving faster than its peers, and therefore has a competitive advantage in sales that its competitors cannot match. From this glimpse, we can now start digging deeper, and determine if there is an actual opportunity underlying this trend.
While it is possible for the cash conversion cycle to demonstrate opportunities to invest in comparatively efficient companies, we need to keep in mind that the metric is only as strong as its components. In this particular case, we need to look next into the inventory management practices of the company that is showing the most efficient conversion practices, and make sure that it is truly showing efficiencies.
For example, a company could artificially bolster its conversion cycle metric by restricting its inventory holdings to inefficient levels, and therefore decrease its ability to provide customer service. While the cash conversion metric would be strong (because products would leave inventory more quickly, because there are fewer of them), the company is likely harming itself in the long run by missing out on sales that would have occurred had the product been on hand immediately when the consumer needed it.
The second step to investigating a favorable cash conversion cycle is to look at the payables aspect of the metric, to make sure that the company is not artificially inflating its efficiency metrics by avoiding the repayment of its trade payables.
For example, if a company were to simply stop paying its suppliers for products over a longer than usual period of time, it would initially show an increase in its conversion cycle metric because it does not see outflows as fast as it sees inflows. However, the company is damaging its relationship with its suppliers, and its credit standing, which will likely cause some dramatic hardships later on in the future. As such, delinquency on minor payables should be seen as a major risk factor, even though it improves the company’s short term ‘efficiencies’ on paper.
