The Cash Conversion Cycle to Help You Pick Winners and Losers

October 15, 2012 | Comments (10)

Written by

Jae Jun

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The Cash Conversion Cycle

The main way a company can make more profit is to simply sell more stuff. But how do you sell more stuff?

You need cash.

Wall Street loves earnings and many people believe earnings drive cash to profitability, but the truth is that cash drives earnings. Cash is king and is the start and the end of a business.

No business can start without cash, and all businesses end in cash, whether it be liquidated or sold out.

This is why a business that can manage its cash efficiently will do better than its competitor.

In the cash conversion cycle, you start off with cash, it becomes inventory and accounts payable, which then becomes sales and accounts receivables before converting into cash again.

The entire cash conversion cycle is a measure of management effectiveness. The lower the better, and a great way to compare competitors.

The Cash Conversion Cycle Formula

Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding

Days Inventory Outstanding

Days Inventory Outstanding shows you in days, how long it takes for inventory to be sold. The quicker inventory is sold, the better.

DIO = (Inventory/COGS) x 365
This is an annual calculation. To calculate between two periods, use the below formula.

DIO = Average inventory/COGS x number of days in period
Average Inventory = (beginning inventory + ending inventory)/2

Days Sales Outstanding

Days Sales Outstanding is the number of days it takes for a company to collect money from sales and involves accounts receivables. Obviously, a low number is better.

DSO=  (Accounts Receivables/Revenue) x 365
This is an annual calculation. To calculate between two periods, use the below formula.

DSO = Average AR / Revenue x number of days in period
Average AR= (beginning AR + ending AR)/2

Days Payables Outstanding

Days Payables Outstanding represents how many days before the company pays it off. The higher the number, the better, because that means the company can use that cash for other profitable purposes before making payments.

DPO = (Accounts Payable/COGS) x 365
This is an annual calculation. To calculate between two periods, use the below formula.

DPO = Average AP / COGS per day
Average AP = (beginning AP + ending AP)/2

Cash Conversion Cycle of Shoe Retailers

See the charts below comparing the cash conversion cycle for Sketchers (SKX), Deckers Outdoor (DECK), Crocs (CROX), Steve Madden (SHOO), and K-Swiss (KSWS).

Since all these companies are involved in making and selling shoes, the cash conversion cycle is all above 50 days, but the company with the best and most consistent record is SHOO.

The worst offender of the bunch is currently K-Swiss. I wish somebody told me about the cash conversion cycle when I bought KSWS back in 2008 and 2009. It sure would have saved me a lot of money because their troubles have continued to escalate.

Here’s a chart that breaks down the cash conversion cycle of K-Swiss.

Although DSO and DPO has been fairly consistent, the increase in DIO should have been a huge warning sign.

The other interesting company to look at is Crocs. If you go and read up on Crocs, you will find out that they had some serious inventory issues in 2007 and the cash conversion cycle climbed vertically before they slashed inventory and got a handle on it again.

Now take a look at the next chart of this series below to see whether cash conversion cycles matters or not.

Steve Madden with the best managed cash conversion cycle climbed 900+% since 2002 with the worst offender, K-Swiss down 65%. Crocs peaked but if you knew about the cash conversion cycle, I’m sure you would have stayed away knowing that the stock was in a bubble. However, after cleaning up its mess, look how Crocs has been performing.

The stock price direction is not entirely dependent on the cash conversion cycle, but it certainly does have a factor and is something you should check regularly too.

All members of the OSV stock valuation and analysis spreadsheets will be able to see the breakdown and use the cash conversion cycle in the official version.

Disclosure

None

  • http://www.valuefolio.com/ Daniel

    Very good discussion of the importance of the cash conversion cycle. I think it works two-fold. It can help you identify companies with exemplary performance and it can also help you identify retailers with room for improvement. But noticing retailers with room for improvement in their cash conversion cycle is no reason to “buy”. This must be accompanies with noticeable actions to begin the long journey of improving this very important cycle.

    Any ratio that improves cash flow is one I like to watch. It reminds me of the Operating Ratio in the railroad industry. Since maintaining operations takes up such a large portion of revenue in railroads, any improvement in this ratio means more cash for building value. It too. Any improvement in the operating ratio, just like an improvement in the cash conversion cycle, usually results in more cash and dramatic appreciation of the stock…

    Where do you think the benefits of improvements in the cash conversion cycle are realized first? The cash flow statement or the income statement?

  • Trebek

    Great article and analysis, Jae. Was Steve Madden ever considered a value stock? I have looked at some of the other shoe companies in the past and thankfully for whatever reasons I stayed away. However, this is an interesting tool that hopefully may help spot turnarounds as well.

  • Nithi

    Hello,
    Thanks for the article
    Was wondering what implication of the inventory valuation method on the Inventory Days
    Avg cost, specific cost, FIFO and LIFO
    Thank you

  • http://www.oldschoolvalue.com/ Old School Value

    Yes it certainly does work both ways. I forgot to mention SKX, but if you look at its CCC above, it has been declining consistently. And then compare to the YTD performance. Not bad.

    CCC will affect the cash flow definitely because the more cash, they more they can buy inventory and sell it. At the end of the period, that’s when all the numbers come together to show how profitable the company has been.

  • http://www.oldschoolvalue.com/ Old School Value

    It was never a “value” stock, but I certainly did look at it quite often. Back when I was invested in KSWS, DECK and SHOO were the best of breed. Shame I didn’t know it back then.

  • http://www.oldschoolvalue.com/ Old School Value

    Inventory valuation is a different topic and not related to the actual cash conversion cycle, because the CCC is all about how quickly assets can turn in cash so that it can be used again.

    FIFO, LIFO etc is important for the balance sheet at the end of the period.

  • LG

    Is evaluation method from one of Bruce Greenwald’s books?

  • http://www.oldschoolvalue.com/ Old School Value

    no, it’s just an accounting method. Been around for a long time, just not used by many people because accounting analysis isn’t well used outside of value ivnesting.

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