Why would a firm's profitablility increase if it lowered its cash conversion cycle?

Answer 1

Cash Conversion Cycle (CCC) is a metric that expresses the length of time, in days, a company takes in order to convert resource inputs into actual cash flows. It attempts to measure the amount of time each net input dollar is tied up in the production and sales process before it is converted into cash through sale to customers. This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties. Also known as "cash cycle".

Usually a company acquires inventory on credit, which results in accounts payable. A company can also sell products on credit, which results in accounts receivable. Cash, therefore, is not involved until the company pays the accounts payable and collects accounts receivable. So the cash conversion cycle measures the time between outlay of cash and cash recovery.

This cycle is extremely important for retailers and similar businesses. This measure illustrates how quickly a company can convert its products into cash through sales. The shorter the cycle, the less time capital is tied up in the business process, and thus the better for the company's bottom line.

The cash conversion cycle simply indicates the duration of time it takes the firm to convert its activities requiring cash into cash returns. Therefore, a downward trend in this cycle is a positive signal while an upward trend is a negative signal. Why is this so? When the cash conversion cycle shortens, cash becomes free for other uses such as investing in new capital, spending on equipment and infrastructure, as well as preparing for possible share buybacks down the road. On the flip side, when the cash conversion cycle lengthens, cash remains tied up in the firm's core operations, leaving little leeway for other uses of this cash flow.