## Monday, February 27, 2012

### Working Capital – Inventory Economic Order Quantity

Today we explore a little more closely the analysis of inventory consistent with our Cash Conversion Cycle metrics and the particular nuances of inventory and its impact on our risk and cost of capital (discussed in last week’s “Working Capital – Finance and Inventory”post).

Economic Order Quantity
One of the first equations we run across when discussing inventory is the Economic Order Quantity. This calculation balances per batch costs with ongoing carrying costs of the inventory in order to determine when additional inventory should either be:
·         Ordered, as the case in raw material for a production process, or a distributor or retail operator, or
 Figure A
·         Produced – in the case of scheduling production runs to satisfy customer demand for a product
﻿
The Economic Order Quantity formula is shown in Figure A.
﻿
Figure B shows the result of this calculation if we have a firm with a demand of 120,000 units per year (D), each with a value of ²100 (C), a carrying cost of 50% (k), and a per batch cost of ²1000 (S), then our optimal order quantity is about 693 units.
 Figure B
One practice that separates a good analysis from a poor one is the process of finding ways to validate or “prove out” the results. I call this process triangulating, since we rely on more than one process to move us toward our objective.
 Figure C
In this case, we can validate our result by simply calculating the costs under different order scenarios. Figure C shows the costs in the previous example under four different reorder scenarios near the 17.3. We note that the lowest total cost in this analysis is 17, followed by 18, with the others being higher. Since 17.3 is between 17 and 18 but closer to 17, this comparison is consistent with the results of our Figure B.

The Benefits of the Economic Order Quantity
The primary benefit of the Economic Order Quantity formula is its simplicity. The entire calculation and result obtained in Figure B took a total of 6 cells in a spreadsheet. It does not get much simpler than that!
While there are drawbacks to this formula (which we will discuss next), for many routine, low value items, it might not make any sense to go any further than this type of calculation. For instance, six cells in a spreadsheet might be a great way to order pencils or paperclips (though even that much analysis might be too much!).

The Drawbacks of the Economic Order Quantity
The underlying assumption in the Economic Order Quantity formula is that pace of the material is even throughout the year. In many cases, this is not realistic. A US retailer using this method will be substantially overstocked during the summer since a large part of retail sales is related to the Christmas holiday season.
In addition to pace, there is linearity in the formula which can also be problematic. Costs (both per batch and per unit) are fixed and do not vary. This is often not the case in real-life. At some point a new person needs to added to the warehouse staff if inventory levels get too high, so the cost function can be step-wise rather than linear. Or there will be economies of scale in some of the other costs, like insurance.

The Hidden Traps in Economic Order Quantity
In addition to the disadvantages, there are other “traps” which might be present in the calculation, primarily related to the difficulties that are sometimes present when attempting to make accounting information actionable from a finance perspective.
When we consider a concept such as carrying costs, the cost of the inventory infrastructure will be allocated to the inventory and included in any accounting perspective of carrying costs.
Yet, once our warehouse is built, this and the cost that go along with it is “sunk” from a continuing investment perspective, but it will not show up that way in a fully allocated accounting calculation.
For instance, if we have a warehouse that we heat and keep lighted at ²100 per year, we will spend this ²100 no matter whether there are 10 items in the facility or 100. Let’s say our per item cost of inventory is ²100. So if we carry 10 items on average per year our inventory costs ²1,000, and our carrying cost rate will be 10%. If we keep 100 units, it will be 1%.
Because this carrying cost charge is in the EOQ formula, it will impact the Q that ends up being calculated.
Yet, re-stating what was said at the beginning of the example, we will spend ²100 no matter what. As such, the optimal Q for our firm can only be calculated if we can remove that data.
In addition to carrying charge, often our inventory will include other sunk or immaterial-to-the-Q-calculation items in its cost, for reasons we have discussed in other posts – such as actual vs. standard costing, the breakdown of direct manufacturing vs. overhead, and the allocation of both thereof.

Key Takeaways
The Economic Order Quantity formula can serve, in certain circumstances, as an efficient means of ensuring that we invest the correct amount of funds into this working capital category. However, we need to be mindful of adjustments to the data we have on hand in order to ensure that the formula includes only economically relevant decision factors.
Questions
·         What has your experience been with the Economic Order Quantity formula?

## Sunday, February 19, 2012

### Working Capital – Finance and Inventory

The most complicated of the “basic” working capital categories involved in the Cash Conversion Cycle is inventory. This is true for a number of reasons.
Inventory is often highly specific to its particular industry. Inventory can take several different forms. Inventory's valuation can vary. In addition, inventory is inextricably entwined with operations, sales and purchasing.
For all these reasons, a careful look at this investment is useful.

Stages
The different stages of the production process results in three separate types of inventory. The firm buys “raw materials” that it will use to convert into its products. During the production phase inventory is classified as “work in process”, or WIP. Finally, “finished goods” is the term used to denote inventory that is ready for sale, shipment and delivery.
Depending on the firm, the amount and proportion of inventory comprising these stages will vary. On one end, a firm whose production process requires very little time and its output can be delivered quickly might hold most of its inventory as raw materials.
For example, a bakery does not want to hold a lot of baked bread, which goes stale and moldy as a finished good, so it is far more optimal to keep flour, yeast, butter and the like in its original state until it can all be delivered early in the morning to its customers in just the right amounts.
A long production process, such as a brewery whose product requires fermentation for several weeks, will see a high amount of WIP, as most of its inventory will be in the fermentation vats.
A simple assembly operation, which assembles quickly but batches up units for high volume bulk sales, will hold a higher amount of finished goods.

Inventory and Cost of Capital
Just as we saw when we examined Accounts Receivable, our firm’s inventory policy will carry different implications for its cost of capital. In the case of Accounts Receivable, we could look to a replicating portfolio to arrive at this impact.  Unfortunately, it is not as simple as that with inventory.
One factor that makes inventory more or less risky is the level of commoditization.  The more inventory we hold in a commodity-like state lowers our risk level vs. the amount held in a non-commodity like state.
If we manufacture a specific part for a specific vehicle, for example, our finished goods are very specialized. We can sell them to only one customer, and then only so long as they continue selling the product for which ours is a part. In other words, our finished goods are not commodities at all.
On the other hand, if our raw material is ingots of iron, these can be sold to a large number of manufacturers making any number of different products in a multitude of industries.
Therefore, a business with a large amount of finished goods in relation to total inventory is more risky than one that holds a larger amount in raw materials.
Each firm must ascertain where in the process this occurs. It is not as simple as saying “raw materials are less risky than finished goods”.
What if we are the firm that receives the vehicle parts manufactured from iron ingots above? Our raw materials are very specific, say part of a car door for a specific model. If the manufacturing process were to shut down permanently, the only use for our raw material is scrap. On the other hand, as a finished good the car can at least be sold, even if it is not for the full list price.
So for the firm in the first example raw materials is the less risky category, while for the firm in the second example finished goods are.

Cost of Capital Worked Example
Let us say that Firm A generates ²1 per year forever, and its cost of capital for this industry is 10%. A perpetuity valuation method then places the value of this firm at ²10. Let’s further say that they paid for their production assets and infrastructure at just this amount, so their Net Present Value was ²0.
In addition, Firm A runs production continuously with a buffer stock of finished goods worth ²2. This is their working capital investment. Since the value of the finished goods in theory revolves around the state of Firm A’s industry, we can say that they should carry the same cost of capital, or 10%.
Just as we did in the last post, we use the Modigliani-Miller assumptions and determine that if we finance the firm with 50% debt at 7%, then our 50% equity is priced at 13%.
﻿﻿﻿﻿
 Figure A
Figure A shows Firm A in comparison to Firm B.
For Firm B, we assume all the above assumptions above hold, with the exception that Firm B keeps its inventory as raw material and produces to order only (like the car part manufacturer whose raw material is iron ingots).
In this case, the raw material inventory is more commodity-like. Commodity futures and forward contracts typically use short-term risk-free interest rates to discount their value vs. spot rates, and so for this reason we assign a lower cost of capital (i.e. risk) to this raw material investment, say 5%.
At our 50/50 capital structure, Firm B’s cost of equity is 11.3%, much lower than Firm A’s.
From this example we can see that our inventory and production policy, methods, and practices will have an impact on our firm’s value due to the cost of capital implications.

The Process Matters
As we just noted, the production process, the nature of the input materials and output materials all impact the working capital requirements of our inventory.
We can say, in general, our inventory practices are dependent on the following factors and questions, which need to be optimized for our firm:
·         Supply variability – is the supply of raw materials highly variable in terms of either price or quantity?
·         Batch supply costs – is there a high “up-front” cost to ordering, receiving, or storing needed raw materials?
·         Per unit supply costs – are these costs different depending on the quantity level of the production run?
·         Physical per unit inventory storage costs – we need space, insurance, and infrastructure to warehouse inventory in any form.
·         Production rates – will manufacturing our product in different amounts affect our productivity?
·         Production variability – are there factors that impact our ability to produce?
·         Batch sales order costs – are there “up-front” costs on the part of our customers, or batching synergies on our part, to fulfilling sales orders?
·         Per unit sales prices – is there variability in what our ultimate realized sales price will be?
·         Demand variability – are there factors that can make our sales volumes dramatically different?
·         Stock-out impact on sales – if we do not have product in stock, will our customers back-order or will we lose the sale entirely to competitors?
This entire process can be subjected to analytical treatment, which we will investigate in future Treasury Café posts.

Our discussion of inventory to this point has been geared to a one-product / one-raw-material type of firm. This is somewhat simplistic. What if we manufacture 100 different items? And utilize 100 different raw materials?
Our analysis then involves the inter-relationship of each product, its manufacturing process, and its sales profile with all the other products in our “portfolio”.
As an example - simplifying the issue to a two product case - what is our optimal production process if product A has very small batch costs, while product B has large ones?
In this instance, we would want to optimize product B’s production schedule and “fill in the holes” with product A’s. Our solution would be entirely different if product A and product B had similar batch and unit costs but faced different variability in either raw material supply or finished good demand, along with different stock-out costs.

Key Takeaways
The inventory characteristics of our firm will impact our working capital level and the resulting risks undertaken, thereby impacting the cost of the capital required to be deployed.

Questions
What inventory peculiarities are present in your industry?
What is the optimal production process given the levels of risk in raw materials, WIP, and finished goods? Why?

## Monday, February 13, 2012

### Working Capital – Finance and Accounts Receivable

In “Working Capital Primer: How is it that this Capital Works?”, we left with a promise to look a little more at the finance dynamics of working capital.

Back to Net Present Value – with a Twist
When we perform Net Present Value (NPV) calculation, we discount these cash flows at the appropriate cost of capital. Often we discount the net cash flow using a cost of capital that we have derived from the Capital Asset Pricing Model (CAPM) in one of its one-thousand plus manifestations.
While this is the usual practice, some theorists will tell us that we should discount each separate cash flow at its appropriate cost of capital, and build up to the result. This is very difficult to accomplish reliably and credibly.
When considering some of the components of working capital, however, we are not as constrained by such real-life practicalities.

Can We Re-Invent the Security?
 Figure A
When preparing a valuation, we often use a “replicating portfolio” to confirm correct pricing. A replicating portfolio simply means a combination of other financial instruments that, when taken together, are identical to the original item.
The classic example is a forward contract, which has a payout profile shown in figure A:
 Figure B
By combining a written put option, with a profile of that shown in Figure B, with a purchased call option, with a profile in figure C, we arrive at the same payout as the forward contract. In this case the options together are the “replicating portfolio” for the forward contract.
 Figure C
The pricing of the put and the call need to be equivalent to the forward, otherwise an arbitrage opportunity occurs. Given that free money does not last forever, even when there is an arbitrage it is fleeting.

Why the Cost of Capital is Different
So let us assume that we have valued our firm’s cash flows at 10%, and this is based on a CAPM analysis using “cash-on-the-barrelhead” comparable companies. However, let’s assume that our firm is willing to extend 30-day payment terms to its customers. Is our firm’s cost of capital the same?
No, because for an investor to replicate our cash flow profile, they would need to both invest in a “cash-on-the-barrelhead” company and a 30-day debt obligation that matches the customer’s risk profile. Thus, the cost of capital of the two-firms is different.
We can evaluate this mathematically. Let us suppose that our “cash-on-the-barrelhead” firm has a 10% cost of capital, generates ²10 in cash inflows per year and ²9 in cash outflows per year, and we assume these will continue in perpetuity (to make the math really simple). The value of this firm is ²10, as shown in Figure D.
If we allow a 30-day payment period for our receivables, and the cost of obligations for similar rated entities as our customers is 5%, then our ²10 of cash inflows needs to be discounted by one month’s cost of capital at 5% in order for us to reflect the market’s valuation. The value of our firm is then ²9.59, as shown in Figure E.
We therefore lower our equity value by ²0.41 by allowing 30-day terms, due to the fact that we have taken on more risk.
Another way to look at this is from the balance sheet perspective. If both are financed at 50% debt, then the equity holder’s risk is lower for the cash-on-the-barrelhead firm than (13% vs. 13.8%).

Looking Closer – Pros and Cons
There are advantages and disadvantages to financing accounts receivable. In our just-completed valuation, it appears to be a disadvantage. However, if we generate additional sales because we grant customers credit, this disadvantage might be overcome.
Continuing with the previous example, what is the level of sales required (at 90% margin) to make our firm worth ²10? The answer to this is that if we generate enough sales to yield cash inflows of ²10.42292 per year, our firm will be valued at ²10, as in Figure F.
However, there are also additional operating costs associated with accounts receivable compared with a “cash-on-the-barrelhead” alternative. We need increased records management and accounting activity. We will incur collections expense. We will need to engage in a credit approval process. We are subject to invoice adjustments while the receivable remains outstanding. Inevitably, some customers will not pay.
Therefore, the decisions we make about accounts receivable policy become subject to a traditional cost/benefit analysis, where we include increase in sales, increased operating costs, and increased costs of additional risk.

Capital Structure Implications
Franco Modigliani and Merton Miller won a Nobel Prize for their insight that the financing of a firm does not matter in a world without taxes, bankruptcy costs, agency costs, asymmetric information, and efficient markets. In other words, not the real-world!
However, if we hold in abeyance this fact, we can explore the financing structure of our firm related to this accounts receivable issue.
If we obtain revolving type lines of credit, or debt with a collateral position in the more liquid assets, this can usually be obtained at lower rates, since the risk is lower because the assets are more liquid and more certain to be collected (there are laws that say if you got goods and services, you have to pay for them).
However, since this benefit was shared by the debtholders and equity holders in the Figure E capital structure, introducing a separate financing at lower rates merely pumps up the required rates of return of the remaining security holders. They are in a riskier position since they accepted lower rate financing, which is lower rate precisely for the fact that the lenders providing it have “first dibs”.

Reducing Days Sales Outstanding
If we want to lower our exposure to accounts receivable, or in other words reduce the Days Sales Outstanding, there are several actions we can consider:
Sell on shorter terms – payment in 15 days instead of 30.
Reminder and Collection Calls – make phone calls to those close to being overdue, or immediately upon becoming overdue, and then follow-up persistently.
Monitor Aging – look for companies that have balances in different aging “buckets”, and evaluate the feasibility of continuing business with them.
Subsequent Sales – do not make shipments to those overdue on bills.
Require Collateral – implement a collateral requirement with customers – they must keep an amount on deposit in order to purchase on credit terms, or they must have pre-paid the invoice prior to shipment occurring or service rendered.

Key Takeaways
Working Capital practices impact both the cost of capital and capital structure elements of our organization. We need to make decisions keeping the consequences in mind.

Questions
·         What practices have you seen that have reduced Days Sales Outstanding?
·         What consequences of Working Capital decisions have you witnessed?

## Tuesday, February 7, 2012

### Working Capital Primer: How is it that this Capital Works?

In the last Treasury Café post, “Cash Conversion Cycle – A Good Measure?”, we discussed one potential metric to evaluate our organization’s working capital proficiency.
Taking a step back from that post, we can consider the fact that working capital is many things:
·         Well understood
·         Always accounted for
·         Strategically assessed
…not being among them!
What exactly is working capital? What are the differences in how working capital can be evaluated? How can working capital be financed?
We touch on the answers to these questions here.

What Is Working Capital?
According to Investopedia, Working Capital is “the cash a business requires for day-to-day operations, or, more specifically, for financing the conversion of raw materials into finished goods, which the company sells for payment.“
According to Wikipedia, Working Capital is “a financial metric which represents operating liquidity available to a business, organization or other entity”
Cash generation and usage, liquidity, and financing of operations are at the heart of working capital.

Working Capital Example
In a small group meeting we can illustrate the definitions above as follows:
We have 4 people – Charlie, her parents, her customers, and her suppliers.
 First Month
Charlie needs to buy raw materials to turn into widgets for her customers, and pay people to run the machines, and pay the landlord rent, and the equipment supplier their lease payment, and the investors their dividends and interest. All this costs her ²10 (for new readers, ² is the symbol for Treasury Café Monetary Units, or TCMU’s), and she needs to deliver this by the end of the month. We call these people, in aggregate, suppliers.
However, since she just started out, Charlie does not have this ²10, so she borrows it from her parents. At month end she pays the suppliers and delivers widgets to her customers. The cash pattern for this is depicted in the figure "First Month".
 Recurring Month
The following month end, customers give Charlie ²10 for the widgets they got at the end of last month. Furthermore, Charlie in turn gives ²10 to her suppliers again for the current month’s activity. This pattern will repeat each month, as shown in the figure "Recurring Month".

Notice that Charlie’s parents do not ever get their funds back during this process. This is because the original ²10 is continually being re-cycled to fund the operations.
Let’s say after a period of time Charlie decides to close down. The final month’s cash flow will be depicted in the "Final Month" diagram.
 Final Month
Charlie is finally able to pay back her parents!
Notice the critical nature of the working capital investment in this case - Charlie only has the funding to pay it off once the operations related to it are over.
This concept of “over” is important, and we will get back to it shortly.
Note that this example above can be conducted in small settings with real funds to illustrate the point with only the initial ²10. If you would like to do this, the only addition step you would need to do  would be to move the ²10 between supplier and customer due to “all other economic activity” or something during the period. This is sometimes helpful for non-finance types to understand experientially what working capital is.

Working Capital Classification
Working Capital is often classified as “temporary” or “permanent”. This system comes about if we consider the organization’s assets by class over a period of time. The graph on the right depicts a cyclical firm with fixed assets and working capital assets (demarcated by the solid brown line). It then further divides the working capital assets (by way of the dotted red line) into permanent and temporary.
Permanent working capital assets are from the point of the fixed assets to the trough of the cycle. They are defined as such because they always exist no matter where we are in the cycle.
Temporary working capital assets are defined as those between trough and peak. They are defined as such because they disappear at a certain point in the cycle, and their value varies depending on where we are in time.
Often the distinction between the two can get confusing. This is where our concept of “over”, discussed earlier, can be helpful.
A business unit, eager to close the sale on a new deal, might argue that its capital cost should reflect short-term rates because the cash conversion cycle for this will be 40 days. However, we can ask “will the business with this customer be over then?” If we find that “No, we will be doing a new deal with them next month if this goes well, and every month thereafter” rather than “Yes, it is a one-shot deal” then the working capital looks to be more permanent and longer-lived (as Charlie’s parents have learned!).
Over time, a firm’s “permanent” and “temporary” working capital will vary. Looking at a graph of a firm growing over time can be illustrative. In this example, both the level of permanent working capital and temporary working capital grows along with the firm.

Financing Working Capital
Financing working capital assets is not an exact science. Some will tell you that the “permanent working capital” portion should be financed with long-term, “permanent” capital (i.e. long-term debt and equity), for the reason that it is permanent and therefore should be financed with something that matches the tenor.
This point of view can be explained by taking Charlie’s parents’ perspective of the situation. In our example above, they provide capital they do not get back until the firm closes its doors, as near a definition to permanent as any free-market enterprise can entertain! They therefore should expect a return commensurate with other long-term investment alternatives.
Alternatively, some would argue that working capital assets be financed at short-term capital rates. This argument relies in part on a different application of the matching principle – short-term assets should be financed by short-term liabilities.
If we consider a liquidation scenario where each investor gets a specific slice of the firm as collateral, then the working capital investors have less to worry about – customers pay their bills in full when due or face enforceable collection efforts, and any finished inventory can be sold for close to market prices provided it is not obsolete for some reason.
Investors with factory equipment, buildings and land face a lot more variability around the ultimate monetary realization and its’ timing. Thus, since the specific nature of the risk and the timing of its occurrence are different, that should lead us to conclude that the investments are different and require different treatment.
We can illustrate how funding can be short-term by modifying our original Charlie example slightly. If, once we collect from customer, add two additional steps to the process, 1) paying back her parents, and then 2) obtaining ²10 either by re-borrowing from her parents or from a new source, prior to her payment to the suppliers. Under this scenario, the provider of working capital funding gets to choose each month whether to continue it or not. Conversely, Charlie is at risk of not obtaining it each and every month as well.
Of course, any point between these two extremes can be chosen as well. We will look at this a little more in-depth in the next Treasury Café post.

Key Takeaways
Working Capital funding is an essential component of the firm’s financial strategy, and working capital requirements are an important factor to consider as the firm evaluates its opportunities and its needs.
Questions
·         Does everyone in your organization have a solid understanding of Working Capital?
·         Do you have a preference as to Working Capital financing? Why?

## Thursday, February 2, 2012

### Cash Conversion Cycle – A Good Measure?

If you google “Cash Conversion Cycle Calculation”, you will find many, many websites that provide the equations, give some simple examples, and send you forth with encouragement about using this fantastic tool in your work.
However, in real-life it is not really all that simple as it sometimes sounds. In this post we investigate some of the “potholes in the road” you may encounter as you attempt to employ the Cash Conversion Cycle calculation.

Cash Conversion Cycle – Intent and Calculation
The Cash Conversion Cycle (CCC) is one of the metrics that firms can use to track working capital efficiency in their operations. Once we come up with the Cash Conversion Cycle number and its components, we can compare the results against 1) accepted rules of thumb or standards, 2) industry averages, 3) our own prior period experiences as a trend or time series analysis.
The measure also helps us develop balance sheet elements in pro forma financial statements for valuation, growth investment scenarios, or merger and acquisition prospects.
Finally, another common usage is that of comparing the working capital efficiency of different firms with each other.
The Cash Conversion Cycle calculation equations are as follows:

As an example, let’s assume our firm has the following income statement and balance sheet:
From the above, the Cash Conversion Cycle calculation is as follows:
This is the point where reality intervenes.
The Cash Conversion Cycle, like all metrics, requires some thought as to the measure’s usage, appropriateness, and limitations. We must understand how the “black box” operates in order to determine whether we are achieving the objectives of the investigation.

Cash Conversion Cycle – Revenue Potholes
Each business has its unique sales and revenue profile. Difficulty with the Cash Conversion Cycle calculation can appear when different business lines are blended together.
For instance, if we calculate DSO for McDonald’s (see McDonalds financial statements if interested) , it is 17.9 days. When thinking about converting accounts receivable to cash, that is a great number!
However, I cannot remember the last time I got a Big Mac and told them to send me an invoice!
McDonalds operates company stores and franchises stores to others - two separate businesses (even though they both have to do with restaurants). The issue here is that the line of business related to the accounts receivable balances primarily pertains to the franchising activity, which involve rent, royalties, and percentage of sales payments. These will be periodic payments, giving rise to accounts receivable balances. Using only the franchise revenues as the figure in our DSO calculation, we arrive at 54.9 days.
What if we are performing an industry comparison instead?
If our comparison companies have 100% company-owned stores, then the 17.9 days we calculated will look high compared to theirs. Yet is it reasonable to conclude we are performing less than they? In theory, we should be about the same, because on a company-store only basis both firms will be “cash on the barrelhead” businesses.
What if the comparison companies are 100% franchise? Then our 17.9 days will look low, and we will pat ourselves on the back for doing a great job, even though this might not be the case on an apples-to-apples basis. Fortunately, in this case we have the information to get to the 54.9 day number.
But what if the comparable companies have a mix of company-owned and franchise operations as well, but in different ratios to each other, and they are not separated as on the McDonalds statements? Then we will not be able to make a truly valid comparison at all.
Thus, the objective of the analysis might determine what is better to use. Are we performing the Cash Conversion Cycle calculation in order to pinpoint opportunities to reduce it? Then we should focus on the 2nd version of DSO, as that is likely where we might be able to make inroads.

Cash Conversion Cycle – Inventory and Cost of Goods Sold Potholes
Accounting rules allow us to use four different methods to value inventory – average cost, specific cost, first-in-first-out, and last-in-first-out.
This being the case, any DIO calculation will import these differences into the figure and render a comparison to another firm as apples-to-oranges. Sometimes, the financial statements might provide the data to get the figures comparable (such as a LIFO to FIFO reconciliation), but not always.
In a manufacturing setting, the value of the goods produced includes the raw material cost, direct labor, other direct costs, and allocated manufacturing overhead.
There are different methods a firm can use to allocate overhead. One might do it on the basis of labor time, another on machine time, another based on space occupied.
In addition, the method used to determine the amount to be allocated will also vary. One firm might use a “pool” using balances from one or more financial accounts in the books. Another firm might use a standard cost estimate that was established as part of a study.

Cash Conversion Cycle – Accounts Receivable Potholes
When companies report Accounts Receivable, this number needs to contain an estimate of uncollectible or bad debt expense within it. This amount of uncollectible can often be picked up in the footnotes of the financial statements, and sometimes it is identified on the balance sheet.
So long as we can find the number, we can compare this category with other firms if we are going to view the DSO measure on a grossed up basis.
However, if we are looking on a net basis we need to be careful. If you put the same receivable and sales data in front of five companies, you will get five different bad debt figures. One company will calculate it based on aging buckets, another percentage of sales, one will be aggressive, one will be conservative, etc.

Cash Conversion Cycle – Accounts Payable Potholes
Accounts Payable is a very active one on the balance sheet. Expenses for cost of goods sold are credited to this account.
Hmmm…but so are sales, general and administrative expenses. So are purchases related to capital projects.
The following example takes two companies, who have identical cost of goods sold and sold the same number of units. However, one company is making capital expenditures as part of a growth plan. With the payables portion of these cap ex payments mixed in with the other AP data, we arrive at a different DPO, even though by design we established that they had an identical Cash Conversion Cycle for the current product mix!
Sometimes we can overcome this. We can get a capital expenditure figure from the Statement of Cash Flows. We could make an assumption about the impact this has on payables (e.g. 30 days worth of capex is in AP). Or we could run a linear optimization program to calculate an equilibrium point where AP related to COGS and AP related to Cap Ex is the same number of days outstanding. We will have varying degrees of confidence as to the results this generates, however.

What is the Use?
With all these potholes in the road, we may reconsider the question as to whether we want to make this journey. It can be somewhat tempting to throw our hands up in the air and walk away – what’s the use?
That is certainly an option, but it is not the only one.
If we want to use the Cash Conversion Cycle to compare our own performance over-time, a lot of these potholes do not matter so much. If our methodology of calculating it is consistent from period to period, we will make an apples-to-apples comparison for our own case, using whatever level of detail is appropriate. This is also appropriate if we want to assign additional working capital requirements in a valuation pro forma.
If we want to use the Cash Conversion Cycle to set a benchmark to shoot for, we might use the basic formula, with all its problems, as a first pass, identify the top three or four firms, and do a deeper-dive calculation with just those three or four in order to set the bar for our objectives.
Finally, we can always use the basic Cash Conversion Cycle calculation, but exercise restraint in the conclusions we draw due to our awareness that many potholes are in the road. Do the companies all cluster within 10-15 days of each other? Or do they cluster at different parts of the range? Is the absolute value of the range very wide or close? This information tells us something, it just doesn’t do it to the precision of a soccer score, where we know with absolute certainty team A got one more goal than team B.
Few things in life are that certain anyways. Why should the Cash Conversion Cycle be any different?

Key Takeaways
Financial data gets to the financial statements in a myriad number of ways that can significantly impact the Cash Conversion Cycle calculation. For this reason, we need to temper our conclusions when viewing an analysis of results based on it. If we want a more definitive conclusion, we need to be willing to spend a good amount of time and effort in order to achieve it.

Questions
·       What has been your experience with using the Cash Conversion Cycle calculation?
·       Can you identify other factors in AP, AR, COGS, Sales, and Inventory that might make comparison of two organization’s numbers apples-to-oranges?