MODULE 6 LESSON 1 – OPERATING CYCLE AND CASH

CONVERSION CYCLE
WHAT IS IT
Working Capital is the company’s investment in current assets such as cash, accounts receivable
(customer’s unpaid bills) and inventories

Net Working Capital is the amount of money a company has left over after subtracting current
liabilities from current assets

OPERATING CYCLE is the length of time taken in selling

inventories plus the time taken in recovering cash from
receivables.

In other words, OC is the sum of days of inventory and days

of receivables.

Days of Inventory or Days Sales of Inventory (DSI) is the average number of days a company
takes to sell its inventories. It a measure of the effectiveness of inventory management by a
company.

To determine the DSI, the formula that will be used is:

To get the inventory turnover:

To get the average inventory:

Or this formula:

Illustrative Example:
For the year end 2015 financial statements, ABC Company reported an ending inventory of
P1,000,000 on its balance sheet and a cost of goods sold of P50,000,000 on its income statement.
The company uses 365 days at its accounting period.

How many days does it take ABC Company to sell its inventories?
The 7.3 DSI means that it takes slightly more than 7 days for ABC Company to sell its inventories.

***Generally, a smaller value of DSI is preferred as it indicates that a business is efficient, that a
company is more efficiently and frequently selling off its inventories, which means fast turnover
leading to the potential for higher profits (assuming that sales are being made in profit). A smaller
DSI would minimize the handling costs of inventories, as well as increase cash flows.

***A large DSI indicates slow sales performance or that the company is struggling with obsolete,
high volume inventory and may have excess purchased of inventories. It may also mean that the
company is keeping high inventory levels to meet high customer demand in the future.

Days of Receivables or Days Sales Outstanding (DSO) is the average number of days a company
takes to clear its accounts receivables. It also refers to the average number of days that it takes a
customer to pay the company for sales on credit.

To determine the days of receivables or DSO, the formula that will be used is:

To get the receivable turnover:

To get the average accounts receivable:

Or this formula:

Illustrative Example: XYZ Company had a gross credit sales of P500,000 during the year. It had
sales returns of P50,000. It had accounts receivables of P90,000. The company uses 365 days at its
accounting period.

How many days does it take XYZ Company to clear its accounts receivable?

The 73 DSO means that the company takes 73 days to collect money from its customers on an
average.

***A high DSO suggests that the company is experiencing delays in receiving payments which can
cause cash flow problems.
***A low DSO is preferred as it indicates that the company is getting its payments quickly.

CASH CONVERSION CYCLE is also called “net operating

cycle”, is the length of time (in days) it takes for the initial cash
outflows for goods and services purchased (materials, labor, etc.)
by a company to be realized as cash inflows from sales (cash sales
and in the collection of receivables).

In other words, CCC measures how long it takes a company to

convert cash into inventory, then into sales, and finally back into
cash (or even more cash) again.

To determine the CCC, the formula that will be used is:

But before we can compute for the CCC, we first have to find out what is Days Payables
Outstanding (DPO) and how it is calculated.

Days of Payables or Days Payable Outstanding (DPO) is the average number of days that a
company takes to pay its bills and invoices (payables) to its creditors.

The formula that will be used is:

To get the payables turnover:

To get the average accounts payable:

To get the net credit purchases, the payable turnover treats it as:

Or this formula:

Illustrative Example: TUV Company has accounts payable worth P550,000 on their balance sheet
and cost of goods sold worth P6,000,000 on their income statement for the year ending Dec 31, 2019.
The company uses 365 days at its accounting period.
How many days does it take TUV Company to pay its payables?

The 32.85 DPO means that the company paid its payables in around 33 days after receiving the
bills.

***A higher DPO indicates two things: a company has better credit terms than its competitors and a
company takes more days to pay its bills and creditors. Generally, having a high DPO is
advantageous because it means that the company has extra cash on hand that could be used for
short term investments.
***A low DPO indicates that a company pays its bills relatively quickly.

Now that we know what DPO is and how to compute for it, we go back to the Cash Conversion
Cycle (CCC) with this illustrative example:

Illustrative Example: Silver Trading, an office furniture manufacturing company, takes 20 days to
sells its inventory (DSI), 40 days to collect payment from customers (DSO) and 30 days before
paying its creditors (DPO).

How many days will Silver Trading take in order for its initial cash outflows to be realized as
cash inflows?

The 30 CCC means that it takes Silver Training 30 days to convert its initial cash investment in
inventory back to cash (or even more cash).

***A positive CCC occurs when the time in inventory and accounts receivable is greater than the
time it takes to pay the suppliers. A company won’t want it to be to too high.
***A negative CCC indicates that a company needs less time to sell its inventory (or produce it from
raw materials) and less time to receive cash from its customers compared to time in which it has to
pay its suppliers of inventories (or raw materials).
***A lower CCC indicates that a company has a fast inventory-sales pipeline. In a nutshell, this
means that a company requires less time to sell its inventory and receive cash than it does to pay
inventory suppliers. The lower the CCC, the better for the company.
ACTIVITY

The data below are from Silver Ace Company’s financial statements. The company uses 365-day
year.

Account 2020 2021

Sales 9,000,000 -
Cost of Goods Sold 3,000,000 -
Inventory 1,000,0000 2,000,000
Accounts Receivable 100,000 90,000
Accounts Payable 700,000 800,000

A. Calculate the following (present your solution in good form):

1. Days Sales of Inventory (DSI)

2. Days Sales Outstanding (DSO)

3. Days Payable Outstanding (DPO)

4. Cash Conversion Cycle (CCC)

B. Answer the following questions in not less than 3 sentences. (5 pts each)

1. What can be done to improve the weak DSI of a company?

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2. Say you are a financial manager, you noticed that the DSO and DPO of your company are
both weak. Which of the two would you fix first? Which of the two would you fix first?
…And why?
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3. Based on the CCC you computed in part A, should the company reduce its CCC? If yes,
how? If not, why?
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ASSESSMENT

Directions: Choose the letter of the correct answer.

1. Which component piece of the cash conversion cycle shows improvement if the number of
days increases?
A. Days Sales of Inventory
B. Days Sales Outstanding
C. Days Payable Outstanding
D. Days in the accounting cycle
2. If the DPO is greater than the DSI + DSO, what is the result?
A. Negative CCC
B. Improved CCC
C. Deteriorating CCC
D. Profits are negative
3. The company’s managers should always be certain to maintain the highest possible inventory
turnover.
A. True
B. False
4. The operating cycle is the
A. Sum of number of days of inventory and the average collection period
B. Length of time it takes for the investment of cash into inventory to be returned from
collected accounts
C. Sum of the number of days of inventory and the average collection period, less the
average payment period
5. As the company’s cash conversion cycle increases, the company _______.
A. Becomes less profitable
B. Increase its investment in working capital
C. Reduces its accounts payable period
D. Incurs more shortage costs