Cash Cycle Answer
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Cash Cycle Problem
The cash cycle, also known as the cash conversion cycle (CCC), is a metric that expresses the number of days it takes for a company to convert its investments in inventory and accounts receivable into cash, while also considering the time it takes to pay its accounts payable. It measures how long cash is tied up in the operating cycle. A shorter cash cycle is generally preferable, as it indicates that a company is efficiently managing its working capital and can convert its investments into cash more quickly.
The cash cycle is calculated using three key components:
Days Sales Outstanding (DSO): The average number of days it takes for a company to collect payment after a sale has been made.
Days Inventory Outstanding (DIO): The average number of days it takes for a company to sell its inventory.
Days Payables Outstanding (DPO): The average number of days it takes for a company to pay its suppliers.
To calculate the cash cycle, we first need to determine its individual components:
Components of the Cash Cycle (Formulas)
The formula for the cash cycle is: Cash Cycle = Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) - Days Payables Outstanding (DPO).
Days Inventory Outstanding (DIO): DIO = (Average Inventory / Cost of Goods Sold) × 365 days.
Days Sales Outstanding (DSO): DSO = (Average Accounts Receivable / Credit Sales) × 365 days Note: If credit sales are not specified, total revenue is often used as a proxy.
Practice Problem: Alpha Corp.
Days Payables Outstanding (DPO): DPO = (Average Accounts Payable / Cost of Goods Sold) × 365 days.
Alpha Corp. is a manufacturing company. Below is a summary of its financial data for the past three fiscal years:
Year 1 | Year 2 | Year 3 | |
| Revenue | 1,000,000 | 1,200,000 | 1,500,000 |
| Cost Of Goods Sold | 600,000 | 700,000 | 900,000 |
| Beginning Inventory | 80,000 | 120,000 | 100,000 |
| Ending Inventory | 120,000 | 115,000 | 140,000 |
| Average Inventory | 100,000 | 110,000 | 120,000 |
| Beginning Accounts Receivable | 85,000 | 75,000 | 125,000 |
| Ending Accounts Receivable | 75,000 | 105,000 | 95,000 |
| Average Accounts Receivable | 80,000 | 95,000 | 110,000 |
| Beginning Accounts Payable | 45,000 | 55,000 | 65,000 |
| Ending Accounts Payable | 55,000 | 65,000 | 85,000 |
| Average Accounts Payable | 50,000 | 60,000 | 75,000 |
| Cash Cycle | 59.6 | 55.0 | 45.1 |
We will calculate DSO, DIO, DPO, and then the Cash Cycle for each year.
Objective: Calculate Alpha Corp.'s cash cycle for Year 1, Year 2, and Year 3.
Step-by-Step Calculation
Year 1 Calculations
Days Sales Outstanding (DSO) - Year 1: DSO = ($80,000 / $1,000,000) × 365 = 0.08 × 365 = 29.2 days
Days Inventory Outstanding (DIO) - Year 1: DIO = ($100,000 / $600,000) × 365 = 0.1667 × 365 = 60.8 days (rounded)
Days Payables Outstanding (DPO) - Year 1: DPO = ($50,000 / $600,000) × 365 = 0.0833 × 365 = 30.4 days (rounded)
Cash Cycle - Year 1: Cash Cycle = DSO + DIO - DPO Cash Cycle = 29.2 + 60.8 - 30.4 = 59.6 days
Year 2 Calculations
Days Sales Outstanding (DSO) - Year 2: DSO = ($95,000 / $1,200,000) × 365 = 0.0792 × 365 = 28.9 days (rounded)
Days Inventory Outstanding (DIO) - Year 2: DIO = ($110,000 / $700,000) × 365 = 0.1571 × 365 = 57.4 days (rounded)
Days Payables Outstanding (DPO) - Year 2: DPO = ($60,000 / $700,000) × 365 = 0.0857 × 365 = 31.3 days (rounded)
Cash Cycle - Year 2: Cash Cycle = DSO + DIO - DPO Cash Cycle = 28.9 + 57.4 - 31.3 = 55.0 days
Year 3 Calculations
Days Sales Outstanding (DSO) - Year 3: DSO = ($110,000 / $1,500,000) × 365 = 0.0733 × 365 = 26.8 days (rounded)
Days Inventory Outstanding (DIO) - Year 3: DIO = ($120,000 / $900,000) × 365 = 0.1333 × 365 = 48.7 days (rounded)
Days Payables Outstanding (DPO) - Year 3: DPO = ($75,000 / $900,000) × 365 = 0.0833 × 365 = 30.4 days (rounded)
Cash Cycle - Year 3: Cash Cycle = DSO + DIO - DPO Cash Cycle = 26.8 + 48.7 - 30.4= 45.1 days
The calculated cash cycles for Alpha Corp. over the three years are:
Summary of Results
Cash Cycle - Year 3: Cash Cycle = DSO + DIO - DPO Cash Cycle = 26.8 + 48.7 - 30.4 = 45.1 days
Year 1 (2022): 59.6 days
Year 2 (2023): 55.0 days
Year 3 (2024): 45.1 days
Alpha Corp. has successfully reduced its cash cycle over the three years, indicating improved efficiency in managing its working capital.