A Cash Conversion Cycle Approach to Liquidity Analysis

A Cash Conversion Cycle Approach to Liquidity AnalysisAuthor(s): Verlyn D. Richards and Eugene J. LaughlinSource: Financial Management, Vol. 9, No. 1 (Spring, 1980), pp. 32-38Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665310 .Accessed: 26/01/2015 05:42

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A Cash Conversion Cycle Approach to Liquidity Analysis

Verlyn D. Richards and Eugene J. Laughlin

The authors both teach at the College of Business Administration at Kansas State University, where Verlyn Richards is Professor of Finance and Eugene Laughlin is Professor of Accounting.

Introduction

Although working capital management receives less attention in the literature than longer-term investment and financing decisions, it occupies the major portion of a financial manager's time and attention [9, p. 173]. In part, this simply reflects the repetitive nature of investment commitments with relatively short life expectancy and rapid transformation from one investment form to another [6, pp. 1-2]. The time devoted to working capital management, however, also reflects the crucial liquidity - or repayment capability - implications of a firm's short-term investment and financing policies. Inattention to the liquidity management process may cause severe difficulties and losses due to adverse short-run developments even for the firm with favorable long-run prospects. Incorrect evaluation of the liquidity implications of a firm's working capital needs may, in turn, subject creditors and investors to an unanticipated risk of default.

Financial managers and their external financial analyst counterparts recognize, at least intuitively, that all working capital investments do not enjoy the same life expectancy, nor are they transformed into

usable liquidity flows at the same speed. It is not clear, however, that they recognize explicitly the crucial role of these differences in evaluating a firm's liquidity position. A cash conversion cycle approach to working capital management illustrates the potential danger of an intuitive approach to liquidity analysis.

The Static View

Financial analysts traditionally have viewed the current ratio as a key indicator of a firm's liquidity position. Logue and Merville, in an empirical study of the capital asset pricing model, state this traditional view when they observe that:

As our liquidity variable, the current ratio (CR) - current assets divided by current liabilities - was chosen. Even a cursory review of most investment texts suggests this variable's importance: it is widely understood by investors; has more intuitive appeal than other measures, such as short-term assets divided by total assets; and was found in the study by Beaver, Kettler and Scholes [2] to be highly correlated with Beta [5, p. 40].

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RICHARDS AND LAUGHLIN/LIQUIDITY ANALYSIS

Generalizations such as these must be viewed with caution. They fail to recognize that the basic liquidity protection against unanticipated discrepancies in the amount and timing of operating cash inflows and outflows is provided by a firm's cash reserve investments in combination with its unused borrowing capacity rather than by total current asset coverage of out- standing current liabilities.

Inter-firm and inter-period comparisons of current ratio statistics are of questionable value to the financial analyst because of qualitative differences in the liquidity attributes of current asset investments. A concentration of current assets in the less liquid receivables and inventory forms may create an increasing current ratio reflecting a deteriorating ability by the firm to cover its current liabilities rather than an improved liquidity position for the firm. Analysts responded to this problem by supplementing the current ratio with the more restrictive acid-test ratio, a ratio of the "degree to which a company's current liabilities are covered by the most liquid current assets" [1, p. 7]. By eliminating the relatively illiquid inventories and prepaid operating expenses, the acid- test ratio relates a firm's current liabilities to its remaining current asset commitments to cash, near- cash, and receivables. "Thus, the quick or acid-test ratio is a much more severe test of current liquidity than is the working capital ratio" [8, p. 645].

The so-called quick assets in this ratio are presumed to be convertible into cash at approximately their stated balance sheet amounts. Firms may, however, experience distinct differences in the speed with which they can convert receivables, as well as inventories, to usable cash flows. Thus, the acid-test ratio reflects a different, although not necessarily more reliable, test of potential solvency than the current ratio does. The usefulness of both static liquidity indicators is limited by their failure to provide adequate information about cash flow attributes of the transformation process within a firm's working capital position.

Static liquidity indicators emphasize essentially a liquidation, rather than a going-concern, approach to liquidity analysis. The ability to meet a firm's obligations through asset liquidation in the event of default should be viewed as strictly a second line of defense. Investors should focus their concern on avoiding default situations by emphasizing 1) a firm's ability to cover its obligations with cash flows from an employment of inventory and receivable investments within the normal course of the firm's operations, and 2) the sensitivity of these operating cash flows to

declining sales and earnings during periods of economic adversity. Operating cash flow coverage, rather than asset liquidation value, is the crucial element in liquidity analysis.

The Operating Cycle Concept The flow concept of liquidity can be developed by

extending the static balance sheet analysis of potential liquidation value coverage to include income statement measures of a firm's operating activity. In particular, incorporating accounts receivable and inventory turnover measures into an operating cycle concept provides a more appropriate view of liquidity management than does reliance on the current and acid-test ratio indicators of solvency. These additional liquidity measures explicitly recognize that the life expectancies of some working capital components depend "upon the extent to which three basic activities - production, distribution (sales), and collection - are noninstantaneous and unsynchronized" [6, p. 3].

Accounts receivable turnover is an indicator of the frequency with which a firm's average receivables investment is converted into cash. Changes in credit and collection policy have a direct impact on the average outstan- ding accounts receivable balance maintained relative to a firm's annual sales. Granting more liberal terms to a firm's customers creates a larger, and potentially less liquid, current investment in receivables. Unless sales increase at least proportionately to the increase in receivables, this potential deterioration in liquidity will be reflected in a lower receivables turnover and a more extended receivables collection period. Decisions that commit a firm to maintaining larger average receivables investments over a longer time period will inevitably result in higher current and acid-test ratios.

Inventory turnovers depict the frequency with which firms convert their cumulative stock of raw material, work-in-process, and finished goods into product sales. Adopting purchasing, production scheduling, and distribution strategies that require more extensive inventory commitments per dollar of anticipated sales produces a lower turnover ratio. This, in turn, reflects a longer and potentially less liquid inventory holding period. If firms cannot modify either the payment practices established with trade creditors or their access to short-term debt financing provided by non-trade creditors, decisions that create longer and less liquid holding periods will again be accompanied by a higher current ratio indicator of solvency.

The cumulative days per turnover for accounts

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FINANCIAL MANAGEMENT/SPRING 1980

receivable and inventory investments approximates the length of a firm's operating cycle. Incorporating these asset turnovers into an operating cycle concept of the current asset conversion period thereby provides a more realistic, although incomplete, indicator of a firm's liquidity position. The operating cycle concept is deficient as a cash flow measure in that it fails to consider the liquidity requirements imposed on a firm by the time dimension of its current liability commitments. Integrating the time pattern of cash outflow requirements imposed by a firm's current liabilities is as important for liquidity analysis as evaluating the associated time pattern of cash inflows generated by the transformation of its ci rrent asset investments.

The Cash Conversion Cycle The cash conversion cycle, by reflecting the net time

interval between actual cash expenditures on a firm's purchase of productive resources and the ultimate recovery of cash receipts from product sales, es- tablishes the period of time required to convert a dollar of cash disbursements back into a dollar of cash inflow from a firm's regular course of operations. Evaluating the interrelated cash inflow-outflow pattern underlying a more complete approach to liquidity analysis requires an additional flow indicator for current liabilities, however. This flow concept can be derived from a payables turnover ratio relating operating costs requiring current cash expenditures to the accounts payable and accrued payable liabilities created by the short-term deferral of these operating expenditures. The relevant payables turnover ratio will be defined as a firm's annual cash operating expenditures (total operating costs minus depreciation, depletion, amortization, and related charges that do not require current cash outlays) divided by the current trade accounts and notes payable plus other spontaneous liabilities directly associated with deferred payment of these current operating costs.

As in the case of the inventory and receivables turnover concepts, the liquidity implications of a firm's payables turnover experience can be established more clearly by a time interval statement reflecting the firm's average payment period. Specifically, the average payment period - 360 days divided by the annual payables turnover - reflects the average time over which a firm defers payment on the costs in- curred to support its operating activities. While declining inventory and receivable turnover ratios reflect a larger current asset investment that must be financed over a longer operating cycle interval, a declining

payables turnover ratio indicates a larger accumula- tion over a longer period of spontaneous working capital financing provided by trade creditors. The more extended operating cycle associated with a declining inventory and receivables turnover increases a firm's potential liquidity management problem. Conversely, the longer payment period associated with a declining payables turnover tends to moderate the liquidity management problem for a firm.

Introduction of a payables turnover concept points out that liquidity analysis requires explicit recognition of the extent to which four basic activities - purchasing/production, sales, collection, and payment - create flows within the working capital accounts that are noninstantaneous and unsynchronized. The cash conversion cycle concept portrays these flows by integrating respective time intervals derived from a firm's typical receivables, inventory, and payables turnover experience. The concept thereby depicts the residual time interval over which additional, nonspontaneous financing must be negotiated to compensate for the noninstantaneous and unsynchronized nature of a firm's working capital investment flows.

Exhibit 1 illustrates the relationship between a cash conversion cycle indicator of the firm's additional, nonspontaneous working capital financing requirements and the more traditional operating cycle concept of its asset conversion period. The diagram points out that a residual cash flow financing period depicted by the cash conversion cycle will be in- fluenced by either expansion or contraction in any of the three liquidity flow measures: the inventory conversion period, receivables conversion period, or payables deferral period. An increase in the length of the operating cycle without a concomitant lengthening of the payables deferral period creates additional liquidity management problems associated with the need to acquire additional nonspontaneous financing over a longer, and potentially less certain, cash conversion period.

Financial Management Implications of the Cash Conversion Cycle

Working capital provided by vendors in the normal course of a firm's operations is spontaneous financing in the sense that it will automatically increase and decrease over time. The availability of such financing is tied directly to the typical trade credit terms offered by vendors to their customers and the volume of goods and services acquired under these terms. A dis- tinguishing feature of this spontaneous financing is the

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Exhibit 1. Cash Conversion Cycle Product

Sales Inventory Receivables

Conversion Period Conversion Period

~~o -~ ~ Operating Cycle c _ _ Payables _LCash

Deferral Period h Conversion Cycle Cash Outlay

I x 0 : :r

CD

absence of explicit financing charges as long as purchasers pay within the stipulated credit period or within the discount period when a cash discount is offered for early payment. In addition to the spon- taneity and nonexplicit cost attributes, trade credit also provides flexibility to working capital management because "experience shows that it is possible to achieve continuity in the supply of trade credit even in adversity when the credit relationship is well managed" [9, p. 231].

Some instances are found where "manufacturers quite literally supplied all the financing for new firms by selling on credit terms substantially longer than those of the new company" [9, p. 230]. The more typical firm will find, however, that reliance on trade credit can be economically justified for financing only a portion of its working capital investments. The remaining working capital investment requirements must be supported by negotiating explicit nonspontaneous financing arrangements with the firm's creditors and owners. It is the need for, and the liquidity management problems created by, this additional working capital financing requirement that provides the basic rationale for adapting the operating cycle concept to a cash conversion cycle concept of liquidity analysis.

Cash management constraints imposed by the more uncertain cash flows typically associated with a longer cash conversion cycle force firms to modify both the investment and financing aspects of their working capital management policies. From a financial structure standpoint, operating cash flow constraints restrict a firm's ability to support additional working capital financing requirements by supplementing spontaneous trade credit with nontrade sources of short-term credit. Short-term creditors are less in- clined to finance additional working capital investments on which there is a greater risk of default and a greater potential loss in liquidation value in the event of default. Therefore, firms will have to rely more extensively on longer-term financing arrangements to support desired extensions of their non-cash

current asset commitments to less liquid inventory and receivable investments.

From the investment side, firms will be required to maintain additional liquidity reserves in compensating and precautionary balances in order to compete for the additional nonspontaneous financing desired to support a longer and less certain cash conversion cycle. These additional commitments to precautionary balance investments will be required to protect providers of long-term, as well as short-term, financing against unpredictable variations in a firm's pattern of future operating cash flows.

In general, the movement toward a longer cash conversion cycle will produce a larger required commit- ment to cash, as well as non-cash, current asset investments and a less extensive relative ability to finance these investments with current liabilities. Therefore, working capital management policies that create a longer cash conversion cycle can be expected to produce a higher current and acid-test ratio position for the firm. In contrast to the conventional view that higher current and acid-test ratios reflect a more liquid working capital investment position, this analysis suggests that these higher ratio values may simply be the by-product of a more extensive commit- ment to less liquid forms of current asset investments.

Negotiating nonspontaneous financing to support both inventory and receivables investments held beyond the payables deferral period would not be a significant management problem if firms could predict with a high degree 9f certainty the future pattern of their operating cash flows. In an uncertain economic environment, however, the general availability of additional credit financing, and a firm's additional short-term borrowing capability in particular, may be inversely related to the length of its cash conversion cycle. This inverse relationship exists because longer cash conversion cycles reduce the flexibility available to firms in managing their cash flows in the face of economic adversity. The greater potential for being locked into excessive inventory and uncollectible receivables investments reduces a firm's ability to rely on funds derived from operating cash flows for a timely repayment of maturing obligations.

This approach becomes increasingly applicable as firms experience greater volatility in their sales revenue and, therefore, greater uncertainty in predict- ing the amount and timing of their cash receipts in response to changing economic conditions. The importance of this increased unpredictability is magnified, or mitigated, by three additional, interrelated factors: the relative amounts of variable and

35




fixed cash operating expense, the extent of built-in rigidities in the current asset turnovers, and the availability of borrowing capacity to support discon- tinuities in the firm's cash flow pattern. Larger amounts of fixed cash expenses, lower current asset turnovers, and reduced availability of borrowing capacity significantly increase liquidity management problems created by an underlying volatility in revenue. The effect of these three factors is incor- porated in the cash conversion cycle approach to liquidity management.

A Cash Conversion Cycle Illustration Cash conversion cycle analysis can be implemented

for most firms with conventional income statement and balance sheet data. For publicly held firms, this information is generally available in their annual reports to stockholders and their SEC 10-K reports. Exhibit 2 depicts the data required for cash conversion cycle analysis as reported in the financial statements for Martin Marietta Corporation. Exhibit 3 illustrates the firm's liquidity indicators computed from these data. This firm was selected because it reflects the logic of cash conversion cycle analysis reasonably well in an actual rather than a theoretical context.

The primary point, as illustrated by the Martin Marietta experience, is that static liquidity analysis in the form of current and acid-test ratios may not provide meaningful indicators of the liquidity position with respect to the more appropriate cash flow standpoint. The decline in the cash conversion cycle and in the associated need for nonspontaneous financing over the 1975-1978 period is indicative of a moderating liquidity management problem. This contrasts with an implied increase in the liquidity management problem from the declining current ratio viewpoint or an in- determinate change in the firm's liquidity position relative to the mixed behavior pattern in the acid-test ratio. The current ratio, as traditionally interpreted, would appear to give the wrong indicator of change in liquidity position while the acid-test ratio simply fails to indicate clearly a pronounced change in the firm's operating cash flows.

The cash conversion cycle should be evaluated in relation to a firm's maintenance of liquidity reserve investments, its availability of unused borrowing capacity, and potential volatility in the firm's cash flows. Exhibit 3 points out that a supplementary test of liquidity reserve position can be constructed by comparing the firm's cash assets - working cash balances plus temporary cash investments - to its total current assets. The data for Martin Marietta

show that a more rapid recovery of operating cash expenditures has been accompanied by an increasing proportion of current assets held in the most liquid form. In the previous section, we noted that additional liquidity reserves will be required to support a longer and less certain cash conversion cycle. By contrast, an increasing liquidity reserve investment coincident with a shorter and more certain cash conversion cycle would contribute to an improving liquidity position. This observed relationship for Martin Marietta again suggests an improving liquidity position despite a declining current ratio and an indeterminant trend in the acid-test ratio.

Illustrating the interrelationship among the cash conversion cycle, the availability of unused borrowing capacity, and the associated problem of cash flow volatility is beyond the scope of this paper. Procedures for stipulating a firm's borrowing capacity in relation to uncertainty about its future cash flows are not yet well-developed in the literature. Recently, articles by Kim [3], Scott [7], and Kraus and Litzenberger [4] appear to provide useful insights into the problem of evaluating corporate debt capacity. Continued research along the lines they have suggested may allow a more explicit extension of the cash conversion cycle concept to consider the liquidity management effects of debt capacity constraints.

Summary An examination of conventional, static balance

sheet liquidity ratios indicates the inherent potential for misinterpreting a firm's relative liquidity position. The extension of this traditional analysis to include flows embodied in the operating cycle concept through receivable and inventory turnover measures directs attention only to the timing of a firm's cash inflows and excludes from consideration the time element of its cash outflow requirements. Since cash outflows are not synchronized with inflows for the typical firm, such an omission is a serious deficiency in liquidity analysis. Adopting a payables turnover concept ex- tends the operating cycle analysis to incorporate both the relevant outflow and inflow components. The resulting cash conversion cycle analysis provides more explicit insights for managing a firm's working capital position in a manner that will assure the proper amount and timing of funds available to meet a firm's liquidity needs.

References 1. Annual Statement Studies, Philadelphia, Robert Morris

Associates, 1977.

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Exhibit 2. Selected Financial Data for Martin Marietta Corporation (000,000 omitted)*

Year Ended December 31 1978 1977 1976 1975

Net sales $1,758 $1,440 $1,213 $1,053

Cost of goods sold $1,269 $1,030 $ 876 $ 774 Selling, general and

administrative expense 192 161 142 132 Depreciation, depletion,

and amortization 72 66 63 60

Total operating expense $1,533 $1,257 $1,081 $ 966

Net operating income $ 225 $ 183 $ 132 $ 87

Cash and short-term investments $ 204 $ 158 $ 107 $ 46

Notes and accounts receivable 283 227 178 147

Inventories 199 209 199 186 Prepayments and other

current assets 16 11 11 14

Total current assets $ 702 $ 605 $ 495 $ 393

Accounts payable $ 133 $ 106 $ 86 $ 78 Salaries, benefits, and

payroll tax 72 48 37 33 Income taxes 210 151 88 36 Current maturities of

long-term debt 14 16 16 14

Total current liabilities $ 429 $ 321 $ 227 $ 161

*Source: Years 1977 and 1978, Martin Marietta Corporation Annual Report to Stock- holders, 1978. Years 1975 and 1976, Martin Marietta Corporation 10-K reports to the SEC.

Exhibit 3. Liquidity Ratios and Cash Conversion Cycle for Martin Marietta Corporation

1978 1977 1976 1975

Static Ratios: Current Ratio 1.64 1.88 2.18 2.44 Acid-Test Ratio 1.14 1.20 1.26 1.20

Turnover Ratios: Receivables Turnover 6.21 6.34 6.81 7.16 Inventory Turnover 6.38 4.93 4.40 4.16 Payables Turnover* 7.13 7.73 8.28 8.16

Cash Conversion Cycle: Receivables Conversion Period 58 days 57 days 53 days 50 days Inventory Conversion Period 56 days 73 days 82 days 87 days Operating Cycle 114 days 130 days 135 days 137 days Less: Payment Deferral Period 50 days 47 days 43 days 44 days Cash Conversion Cycle 64 days 83 days 92 days 93 days

Supplementary Static Ratio: Cash Assets/Current Assets 0.29 0.26 0.22 0.12

*Cost of goods sold plus selling and general and administrative expense divided by accounts payable plus salaries, benefits, and payroll tax.

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2. W. Beaver, P. Kettler, and M. Scholes, "The Association Between Market Determined and Accounting Deter- mined Risk Measures," The Accounting Review (Oc- tober 1970), pp. 654-682.

3. E. Han Kim, "A Mean-Variance Theory of Optimal Capital Structure and Corporate Debt Capacity," Jour- nal of Finance (March 1978), pp. 45-63.

4. A. Kraus and R. Litzenberger, "A State-Preference Model of Optimal Financial Leverage," Journal of Finance (September 1973), pp. 911-922.

5. Dennis E. Logue and Larry J. Merville, "Financial Policy and Market Expectations," Financial Manage-

ment (Summer 1972), pp. 37-44. 6. Dileep R. Mehta, Working Capital Management,

Englewood Cliffs, N.J., Prentice-Hall, Inc., 1974. 7. James H. Scott, Jr., "A Theory of Optimal Capital

Structure," The Bell Journal of Economics (Spring 1976), pp. 33-54.

8. G. A. Welsch and R. N. Anthony, Fundamentals of Financial Accounting, revised ed., Homewood, Ill., Richard D. Irwin, 1977.

9. J. Fred Weston and Eugene F. Brigham, Essentials of Managerial Finance, 5th ed., Hinsdale, Ill., The Dryden Press, 1979.

FINANCIAL MANAGEMENT ASSOCIATION TENTH ANNUAL MEETING

The Financial Management Association brings together practicing financial managers from industry, financial institutions, and nonprofit and governmental organizations, and members of the academic community with interests in financial and investment decision-making. The tenth annual program, October 23-25, 1980, at the Marriott Hotel in New Orleans, Louisiana, will stress the in- terrelationships between theory and practice in financial and investment management.

1980 Annual Meetings

Dates: October 23-25, 1980

Place: Marriott Hotel New Orleans, Louisiana

Program Participation:

Meeting Arrangements:

Placement Information:

Professor Frank K. Reilly College of Commerce and Business Administration University of Illinois Urbana, Illinois 61801 Tel: (217) 333-6391

Professor Donald Woodland Louisiana State University College of Business Administration Baton Rouge, Louisiana 70803

Professor John Boquist Graduate School of Business Indiana University Bloomington, Indiana 47401 Tel: (812) 337-8568

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Article Contentsp. 32p. 33p. 34p. 35p. 36p. 37p. 38

Issue Table of ContentsFinancial Management, Vol. 9, No. 1 (Spring, 1980), pp. 1-89Front Matter [pp. 1-6]Capital Budgeting: Problems and PracticesCapital Budgeting Methods and Risk: A Further Analysis [pp. 7-11]A Note on Capital Budgeting and the Three Rs [pp. 12-13]An Application of the Capital Asset Pricing Model to Divisional Required Returns [pp. 14-19]Debt Capacity and the Capital Budgeting Decision: A Comment [pp. 20-22]Debt Capacity and the Capital Budgeting Decision: A Revisitation [pp. 23-26]

Paper Selected from the 1979 MeetingsAn Empirical Investigation of Small Bank Stock Valuation and Divided Policy [pp. 27-31]

A Cash Conversion Cycle Approach to Liquidity Analysis [pp. 32-38]The Effect of Forced Conversions on Common Stock Prices [pp. 39-45]The Financial Planning and Management of Real Estate Developments [pp. 46-52]The Use of Financial Ratios in Credit Downgrade Decisions [pp. 53-56]Some Portfolio IssuesOptimal Selection of Passive Portfolios [pp. 57-66]Portfolio Revision: A Turnover-Constrained Approach [pp. 67-75]

The Evaluation of Leveraged Leases [pp. 76-80]Incentive Compensation and REIT Financial Leverage and Asset Risk [pp. 81-87]The Effect of Financial Leverage on Air Carrier Earnings: A Breakeven Analysis: Comment [pp. 88-89]Back Matter

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A Cash Conversion Cycle Approach to Liquidity Analysis