Understanding Cash Conversion Cycle
The Covid pandemic has shown the world the dependence each and every country has on China, and the sheer dominance that single country has on the manufacturing industry all over the world. Well, most of the world’s developed nations are not so happy about this discovery and are now in a plan to reduce their dependence on China. And most of them are now looking forward to India, taking over a large portion of China’s manufacturing market. And the government is all set to push the Indian economy into a manufacturing hub. The govt launching the Atma Nirbhar Bharat (self-reliant India) scheme and introducing PLI (production-linked incentive) schemes, all of which aim to promote all manufacturing possibilities in India.
Hence, if there is high noise in a sector and everybody sees changes happening in the same, as investors we should also take a look into it. So one of the major aspects that drives the Manufacturing Sector is the working capital, and one of the best calculations to understand the working capital flow in the cash conversion cycle.
The Cash Conversion Cycle or the Cash Cycle, or just CCC, is one of the important metrics taken into consideration in order to study the operational efficiency of a firm. There are 2 major aspects taken into consideration while calculating the CCC, the TIME and the CASH. Both of these when put into the calculation provide an insight into a management’s overall operational efficiency and proper use of the working capital. Usually, this calculation is used to compare companies within a particular industry or sector, or are being compared within the company’s past historical records.
In some cases, the CCC may end up being a negative number, which means inventory is sold before you have to pay for it. Or, in other words, your vendors are financing your business operations. A negative cash conversion cycle is a desirable situation for many businesses, which is considered good.
However, CCC does not apply to companies that don’t have the need for inventory management. For instance, software companies that offer computer programs through licensing can realize sales (and profits) without the need to manage stockpiles. Similarly, insurance or brokerage companies don’t buy items wholesale for retail, so CCC doesn’t apply to them.
The cash conversion cycle uses 3 core segments in its calculation. Credit Sales, Inventory & Credit Purchases. The ratio expresses the time taken by the firm to convert the investments in inventory into cash. The cash aspect is taken seriously in calculations of the CCC, as the saying goes “Cash is King” in a manufacturing business.
Cash Conversion Cycle = Days of inventory Outstanding + Days of sales outstanding — Days of Payables Outstanding.
wherein, DIO + DSO = Operating Cycle
Days of Inventory Outstanding (DIO) :
The Days of Inventory Outstanding is the calculation of the average number of days the firm holds its inventory before turning it into sales. Thus, it is good to have this number low, which signifies that the number of days the cash is tied up to the inventory would be less. DIO days higher is not considered good, as it signifies the inventory takes a longer time frame to convert into sales which further increases additional costs on warehousing. In worst-case scenarios, some specific businesses that deal with products that have lower shelf life stocks may become obsolete & unusable.
But some companies also keep the Inventory stockpiled up to meet the seasonal demand fluctuation. So, if the company aims to increase the DIO drastically, they may be preparing for seasonal demand increases. So, it’s better to compare the numbers with the industry peers to get better clarity on the bigger picture.
Formula = (Average Inventory / Cost of Goods sold) * 365
Average Inventory = (Inventory at the beginning + Inventory at the End) * ½
COGS (Direct cost incurred in the production) = Starting Inventory + Purchases — Ending inventory
Now, in order to improve the DIO, companies use various strategies such as:
· Increase accuracy in planning
· Increasing the demand
· Speeding up sales like just-in-time deliveries
· Disposing of obsolete stocks
Days of Sales Outstanding (DSO) :
The second metric taken into consideration is the Days of Sales Outstanding. The DSO days show the average number of days taken by a firm to collect the receivables after sales. In simple terms, how many days does it take for credit sales to convert into cash. Only credit sales are considered on DSO days, as cash sales are considered zero.
The DSO shows some insights into the firm such as:
· Are customers paying back on time
· Operational efficiency
· Customer Relationships
· Performance of Accounts Receivables
Formula = (Average Trade Receivables/Net Credit Sales)*365
The DSO days are preferred to be lower as it shows a proactive collection team and takes lesser time to convert the credit sales into cash. In order to improve DSO firms use certain Strategies such as:
- Offer incentives to customers
- Identify risky customers
- Offer multiple payment options
The DSO can be lower in 2 cases:
- Low numerator: This Shows that the collection team has collected most of the dues.
- Higher denominator: This means that the number or Credit period has been stretched, by the management.
The Addition of both the DSO and DIO is known as the Operating Cycle, which tracks the number of days between the initial date of inventory purchase and the receipt of cash payment from customer credit purchases.
Days of Payable Outstanding (DPO) :
Now coming to the last metric, the Days of Payable Outstanding is a financial ratio that indicates the time (in days) taken for a firm to repay its suppliers, vendors, or financers for the credit purchases made. Usually, a higher DPO is advantageous for the company as it takes a longer time to pay back its creditors which opens the company with more opportunities for short-term investments with the cash in hand.
Now the DSO is a bit different from the above 2 ratios, as with both the above ratios management can choose to follow the thumb rule in order to give the company an efficient use of the working capital. But in the case of the DSO, if the management goes on with the textbook method, i.e. to delay the payments to the creditors, they will have to pay heavy prices for that. Ideally, no company wants its payments to get delayed, as it hurts its working capital. Thus no firms are going to approach them and would have a significant effect on their goodwill and creditworthiness. Also, if the management is going ahead and paying off their creditors before the due date, the investors would question them for not utilizing the credit period allowed to them. Thus, the managers should play it safe, or else they must be companies that are too big to fail. Such firms hold the power to demand delays in payments, for example, Coca-Cola, a well-recognized brand all over the world takes 296 days to pay their creditors, approximately more than 9 months. And this is not just Coca-Cola that is bullying the suppliers, many firms who are big enough are also following the same method.
Professor Narayanan of Harvard said. “They essentially are going to their suppliers for credit, rather than their banks — and for big, creditworthy companies like these, that’s ridiculous.”
Such advantages of being big enough help them bully the suppliers, the big firms promise the suppliers more business for the extended credit period. The same companies are not ready to extend their part of the receivables. Actually, these large companies don’t care about the receivables, they give these receivables as securities to banks and other financial institutions and take money from them(a process known as invoice discounting). Such advantages of being big enough help them bully the suppliers.
Formula = (Average Accounts Payable/Cost of Goods Sold)*365
With all three Metrics covered let’s try to put the numbers into action, note that the assumptions drawn out are only on the Cash Conversion Cycle Metrics alone.
Steel Sector (Companies with market Cap above 5000 crore)
Green Flags:
APL Apollo Tubes shows remarkable outperformance in the industry with just 2.65 CCC. Clearly outperforming all its peers.
Red Flags:
The top 2 companies by market capitalisation, are having a high number in the Inventory days.
Cement sector (Companies with market Cap above 5000 crore)
Green Flags:
India Cements although smaller compared to other players produces -127.2 days of CCC. The 2 Adani-owned companies, ACC & Ambuja Cements both have negative CCC -69.29 & -13.4 respectively.
Most of the companies in the list maintain a decent receivable day, irrespective of their size.
Red Flags:
The inventory days of Shree Cements is at a whooping 877.89 inventory days, which compared to the peers is a lot.
Tyre Manufactures (Companies with a market Cap above 2000 crore)
Green Flags:
CEAT & Goodyear India are the only companies that produce negative CCC among their peers, -6.35 & -0.67 respectively.
Red Flags:
The companies with higher market capitalizations are having very high CCC.
Consumer Electronics (Market Capitalisation above 5000Cr)
Green Flags:
The top 3 market heavyweights have shown solid numbers in the chart, with Dixon technologies leading the race among the 3, with a CCC of 3.06 days. Apart from that Blue Star is able to produce remarkable outperformance of -26.65 CCC. Such a pattern shows the superior dominance the large players have in the market, they have solved the formula for efficient production in the market, in a long run would create entry barriers for new players.
Red Flags:
The other interesting finding in the chart is the 637.59 days Inventory days of Eureka Forbes, way above all its peers, the same company also has the highest payable days of 549.3, which is certainly a red flag to be considered.
Automobiles Manufacturers (Companies with a market cap above 2000 crore)
Green Flags:
Now coming on to the most popular manufacturing segment, we can see that all the big names have negative CCC, among which TATA Motors has the best number of -53.33 & most of these companies have their days of receivables below 50.
Red Flags:
The numbers of Olectra Greentec are quite concerning, as the payable days of 235.27 and the receivables days are also high. Which raises concerns about their creditworthiness & their receivables management of the company.
Pharma Manufactures
Companies above 200 Crore Market Cap were selected in this sector, ending up with a total of 100 plus companies.
Green Flags:
There were 3 interesting companies found in the long list of companies, which produce a negative CCC among their peers, Astrazeneca Pharma and P & G Health Ltd both of which are below 10,000 crore Market Cap but are producing -17.06 & -37.98 days respectively.
The third one Amrutanjan Health is an even smaller company which is just above 2,000 crore market capitalisation and is able to produce -35.27 days of CCC. Considering all the peers a negative CCC in this sector is a rare phenomenon.
Auto Ancillaries (Companies above 5,000 crore Market Cap)
Green Flags:
So, among all the peers only 3 companies have produced good numbers in CCC, Motherson Sumi, Endurance Tech & Sundaram Clayton, with -11.11, 2.43 & -43.9 respectively.
Red Flags:
The inventory days of Crafton Auto & Rolex Rings are both above 200 days
FMCG (Companies above 10,000 crore Market Cap)
So out of the 13 companies in selection, we can see that most of the out-performers are MNCs and are kind of following the Coca-Cola way, i.e. slowing down their payment days which improves their CCC days. The only Indian company that is trying to follow this process is Dabur India, but they are not successful in producing the same numbers as the International Players.
Green Flags:
Most of the well-known big brands have maintained their CCC well.
Red Flags:
Most of the companies in FMCG have their Inventory days high and are dependent a lot on the credit period allotted to them.
Sugar Manufacturers (Companies above 1,000 crore Market Cap)
Green Flags:
Renuka Sugar & EID Parry standing top of the list by market capitalization have led the pack with examples, producing good CCC numbers of 18 & 6 respectively. Being the higher market capped companies, it is expected to have the payable days relatively high among the peers.
Red Flags:
Down at the bottom, the company Bajaj Hindustan Sugar produces a phenomenal number of -97.88. Which is heavily built upon stretched payable days. Which does not look good, as there are peers who would be able to supply goods with better payable days. A problem that would be directly affecting the fundamentals of the company. Along with that the inventory days of Dhampur, are high, reflecting its CCC to be the highest among its peers.
Chemical Manufacturers (Companies above 10,000 crore Market Cap)
This list contains a list of 19 companies out of which 3 companies shine out. The obvious one is Linde India with -207.15, a huge outplay to the rest of the peers. But playing the similar card played by Coca-Cola, stretching the payable days, it is true that TATA Chemicals is also having higher payable days. But viewing their inventory days, there is a scope for improvement for the company. Like they have really high inventory days, so if they can work out good strategies they would be able to reduce the CCC further. Further down the list, we can see Castrol India & Deepak Fertilizer, having CCC of 4.27 & 2.62 respectively, which is a good number comparing the peers but is also dependent upon the Payable days.
Plastic Products (Companies with Market Cap above 5,000 crore)
Green Flags:
The top company by market capitalization has the lowest number of 20.48 days among peers showing the dominance they have in the market.
Red Flags:
Also, we can see the inventory days of VIP Inds, 304.79 a potential red flag concerning their higher CCC number.
Cables Manufactures (Companies above 1,000 crore market capitalization)
Green Flags:
A clear superiority on the CCC number can be seen by Sterlite Tech, that too majorly by the extended payable. Yet another dominant foreign player. They are the world’s largest producer of optic fibre cables in the world and also have a 45% market share in India, which is why they are able to have this demanding power over the other companies.
Red Flags:
Vindhya Telelink seems to be a bit off track as it has higher CCC among all the peers due to higher inventory days and receivables among all the peers. Also, they have the largest payable days among all their peers.
Thus, in this article, we have covered the concept of the Cash Conversion Cycle and have done a practical use-case scenario of the same, on various listed companies in the Indian market.
Hope it was worthwhile, to stay tuned for more finance-related content.
