Definition

Cash conversion efficiency refers to the effectiveness with which a company converts its investments in inventory and other resources into cash flows from sales within a given period.

Description

Cash conversion efficiency is a financial term that measures how well a company uses its resources to create cash flow from its operations. It assesses the effectiveness of converting various components of working capital, such as inventory and accounts receivable, to cash.

At its foundation, cash conversion efficiency is concerned with reducing the time required for a corporation to turn investments in inventory and other assets into cash receipts from customers. 

Several financial ratios and metrics can be used to determine cash conversion efficiency, including:
 

• The Cash Conversion Cycle (CCC): It is the time it takes for a company to convert its inventory and other resource investments into sales-related cash flows. A shorter CCC suggests greater efficiency.
   
• Cash Conversion Ratio: This ratio compares a company's operating cash flow to its net sales revenue, revealing how efficiently it earns cash from sales operations.
   
• Working Capital Turnover: This ratio measures how effectively a company uses its working capital to produce revenue. A greater turnover ratio suggests improved cash conversion efficiency.

Importance of Cash Conversion Efficiency

Here are the reasons why cash conversion efficiency is important:

• Financial Health Check:

Cash conversion efficiency serves as an important indicator of a company's financial health. It assesses a company's ability to convert its investments into cash, reflecting the efficiency of its operations.

• Enhanced Liquidity:

Efficient cash conversion results in faster access to cash from sales. This boosts liquidity, allowing the corporation to satisfy its short-term financial obligations more quickly.

• Risk Reduction:

A high cash conversion efficiency lowers the likelihood of cash flow difficulties. It enables the organisation to better manage unforeseen expenses and economic downturns.

• Effective Resource Allocation:

Understanding cash conversion efficiency allows for more informed resource allocation decisions. Businesses can use their resources more efficiently, optimizing inventory levels and lowering extra expenses.

• Competitive Advantage:

Companies with higher cash conversion efficiency can outperform their competitors. They may offer better prices to clients, negotiate better terms with suppliers, and reinvest capital for expansion, giving them a competitive advantage in the market.

How to calculate cash conversion efficiency?

Calculating cash conversion efficiency involves several steps:

Step 1: Determine Cash Conversion Cycle (CCC):

Calculate the average number of days a business takes to sell goods, collect receivables, and pay accounts payable. Apply the following formula:

CCC = Inventory Conversion Period + Accounts Receivable Period - Accounts Payable Period.

Step 2: Calculate Operating Cash Flow:

Determine the operating cash flow for the same time period that the CCC is determined. The company's cash flow statement includes information on operating cash flow.

Step 3: Compute Cash Conversion Efficiency Ratio:

In the next step, divide the operating cash flow by the average value of working capital for the period. The formula is:

Cash Conversion Efficiency = Operating Cash Flow / Average Working Capital.

Step 4: Interpret Results:

A greater cash conversion efficiency ratio suggests better success in turning working capital into cash. On the other hand, a smaller percentage indicates inefficient cash management and working capital usage.

Step 5: Monitor and Analyse Trends:

Regularly monitor and analyse changes in the cash conversion efficiency ratio over time. Identifying trends can help in assessing the effectiveness of cash management strategies and operational performance.

Trends that can affect CCE computation
 

Some of the trends that can affect the CCE computation:

1. Changes in Inventory Turnover: Fluctuations in inventory turnover can have an impact on CCE calculations. Faster inventory turnover reduces the cash conversion cycle, whereas slower turnover lengthens it.
2. Variations in Accounts Receivable Collection Period: Changes in the time it takes customers to pay their invoices might have an impact on the accounts receivable period component of the cash conversion cycle, altering CCE computation.
3. Shifts in Accounts Payable Payment Terms: Payment terms negotiated with suppliers might change the accounts payable period of the cash conversion cycle, altering CCE computation.
4. Market Demand and Economic Conditions: Changes in market demand and economic situations can have an impact on sales volume, pricing strategies, and payment behaviours, all of which have a direct impact on CCE calculation.

Example

Consider a small clothing store in India that experiences fluctuations in its cash conversion efficiency due to changes in market demand. During a prosperous season, the store's inventory turnover period is 25 days, the accounts receivable period is 35 days, and the accounts payable period is 20 days.

Calculating the Cash Conversion Cycle (CCC) in INR:

CCC=Inventory Conversion Period+Accounts Receivable Period−Accounts Payable Period

CCC=25+35−20

CCC=25days(inventory)+35days (accounts receivable)−20days (accounts payable)

CCC=40days

Suppose the operating cash flow for this period is ₹100,000.

To compute the Cash Conversion Efficiency (CCE) ratio:

CCE=Operating Cash Flow/Average Working Capital

​

CCE=₹100,000/[{(25+35)/2+20}/2]

CCE=₹100,000/50

CCE=₹2000

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FAQ

What does cash conversion efficiency measure?

Cash conversion efficiency assesses a company's ability to convert its investments in inventory and other assets into cash flows from sales over a specified time period.

How is cash conversion efficiency calculated?

The cash conversion efficiency is determined by dividing the operating cash flow by the average working capital. The result shows how much cash is created per working capital unit invested.

Why is cash conversion efficiency important?

Cash conversion efficiency is important since it represents a company's ability to handle working capital effectively. A greater efficiency ratio suggests better liquidity and operational success, whereas a lower ratio may indicate inefficiencies in cash flow management.

How can companies improve their cash conversion efficiency?

Companies can increase cash conversion efficiency by employing measures to streamline inventory management, speed up accounts receivable collection, negotiate favourable payment terms with suppliers, and enhance overall working capital management procedures.