Question

18. Explain, in words, what a cash conversion cycle (also known as days of external financing) of 25 means. List two actions management might take to improve this ratio and briefly describe any negative consequences management might need to be careful about if taking those actions.

Answer 1

Cash conversion cycle is the time taken by a company to convert it's investment in inventory and other resources into cash flow. It is usually measured in days. This measure is also used to compare the efficient of the enterprise.

cash conversion cycle formula is as follows:

Cash Conversion Cycle = DIO + DSO – DPO

Where:

• DIO stands for Days Inventory Outstanding
• DSO stands for Days Sales Outstanding
• DPO stands for Days Payable Outstanding

Cash conversion cycle of 25 means, the company will take 25 days to convert its its investment in inventory and related resources into cash. To elaborate, it says the company required 25 days to sell it's inventory , collect it's accounts receivable and pay off its accounts payable and other bills without incurring any penalties.

Actions management might take to improve this ratio:

Actions to be taken	Negative consequences
Demand the customers to pay sooner. Motivate them to make payment by offering discounts	offering big discounts or offering discounts without planning might end up in loss for the company
Demand discounts from suppliers.	Supplier might give less quality products. Inspect purchases cautiously.

Expand the business to new areas. Hence sales will increase, thus inventory will turn into cash sooner	There will be chances that business might not be successful in new areas. Hence the company should do careful research before such a step
Reduce the inventory,. Hence the investment will decrease. Thus it van be liquefied easily	the company might not end up in stock out and loss is sale. Subsequently it might even result in loss of market share