What Does Cash Conversion Cycle

8/6/2019 What Does Cash Conversion Cycle

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What Does Cash Conversion Cycle - CCCMean?

A metric that expresses the length of time, in days, that it takes for a company to

convert resource inputs into cash flows. The cash conversion cycle attempts to measure the

amount of time each net input dollar is tied up in the production and sales process before it isconverted into cash through sales 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".

Calculated as:

Where:

DIO represents days inventory outstanding

DSO represents days sales outstandingDPO represents days payable outstanding

Investopedia explains Cash Conversion Cycle - CCC

Usually a company acquires inventory on credit, which results in accounts payable. Acompany 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.

Minimum cash balance:


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Liquidity v. Profitability : A Risk return Trade-off

Another important aspect of a working capital policy is to maintain and provide

sufficient liquidity to the firm. Like most corporate financial decisions, the decisions

on how much working capital be maintained involves a trade-off because having a

large net working capital may reduce the liquidity-risk faced by the firm, but it canhave a negative effect on the cash flows. Therefore, the net effect on the value of

the firm should be used to determine the optimal amount of working capital. A firm

must maintain enough cash balance or other liquid assets so that it never faces

problems of payment to liabilities. Does it mean that a firm should maintain

unnecessarily large liquidity to pay the creditors? Can a firm adopt such a policy?

Certainly not. There is also another side of the coin. Greater liquidity makes the firm

meeting easily its payment commitments, but simultaneously greater liquidity

involves cost also.

The risk-return trade-off involved in managing the firms working capital is a trade-

off between the firms liquidity and its profitability. By maintaining a largeinvestment in current assets like cash, inventory, etc., the firm reduces the chances

of (i) production stoppages and the lost sales from the inventory shortages, and

(ii)the inability to pay the creditors on time. However, as the firm increases its

investment in working capital, there is not a corresponding increase in its expected

returns. This means that the firms return on investment drops because the profits

are unchanged while the investment in current assets increases.

In addition to the above, the firms use of current liability versus long term debt also

involves a risk-return trade-off. Other things being equal, the greater the firms

reliance on the short term debts or current liabilities in financing its current assets,

the greater the risk of liquidity. On the other hand, the use of current liability can be

advantageous as it is less costly and flexible means of financing. A firm can reduce

its risk of illiquidity through the use of long term debts at the cost of reduction in its

return on investment. The risk-return trade-off thus involves an increased risk of

illiquidity and the profitability.

So, there exists a trade-off between profitability and liquidity or a trade-off between

risk (liquidity) and return (profitability) with reference to working capital. The risk in

this context is measured by the probability that the firm will become technically

insolvent by not paying current liabilities as they occur; and profitability here means

the reduction of cost of maintaining of current assets. The greater the amount ofliquid assets a firm has, the less risky the firm is. In other words, the more liquid is

the firm, the less likely it is to become insolvent. Conversely, lower levels of liquidity

are associated with increasing levels of risk. So, the relationship of working capital,

the liquidity and risk move in opposite direction. So, every firm, in order to reduce

the risk will tend to increase the liquidity. But, increased liquidity has a cost. If a

firm wants to increase profits by reducing the cost of maintaining the liquidity, then

it must also increase the risk. If it wants to decrease risk, the profitability is also


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decreased. So, a trade-off between risk and return is required. In order to discuss

the risk-return trade-off, the following assumptions are made:

(a) That the current assets are less profitable than the fixed assets,

(b) Short term are cheaper than long funds, and

(c) The firm has a fixed level of total funds inclusive of long term funds and short

term funds; and a fixed level of total assets inclusive of current assets and

fixed assets.

Invest surplus cash

Although part of your business capital needs to be liquid, most businesses have some capital that

can be invested in short- and intermediate-term securities for potentially higher yields. A broad

array of investments can be purchased within a central asset account. And you can sell securities

in your account at any time, or, if appropriate, borrow against their value2, to meet working

capital needs. Be sure to discuss the risks of borrowing against your securities with your

Business Financial Advisor.

Factors affecting investment decisions:

Past market trends

Sometimes history repeats itself; sometimes markets learn from their mistakes. You need tounderstand how various asset classes have performed in the past before planning your finances.

Your risk appetite


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The ability to tolerate risk differs from person to person. It depends on factors such as your

financial responsibilities, your environment, your basic personality, etc. Therefore,

understanding your capacity to take on risk becomes a crucial factor in investment decisionmaking.

Investment horizonHow long can you keep the money invested? The longer the time-horizon, the greater are thereturns that you should expect. Further, the risk element reduces with time.

Investible surplus

How much money are you able to keep aside for investments? The investible surplus plays a

vital role in selecting from various asset classes as the minimum investment amounts differ and

so do the risks and returns.

Investment need

How much money do you need at the time of maturity? This helps you determine the amount ofmoney you need to invest every month or year to reach the magic figure.

Expected returns

The expected rate of returns is a crucial factor as it will guide your choice of investment. Basedon your expectations, you can decide whether you want to invest heavily into equities or debt or

balance your portfolio. The main reason for people investing money is to earn a high return

on the investment. An individual may have various investments. Some may be fixed

investments and others may be high risk equity investments. The individual has to

periodically analyze the rate of return that is being earned from various investments. The

portfolio of the investments may have to be readjusted depending on the rate from each of

the investments. This will help the investor to earn an increased rate of return from various

investments.

Inflation:

Each of the persons investments have to beat the inflation rate present at that time for thereturn on investment to be positive. If the inflation rate is more than the return on the

investment of a person, then the return is negative when inflation is taken into

consideration. Any investment has to beat the inflation to be efficient.

Tax benefits:

Tax benefits are a very important aspect to be considered when a person is investing. Tax

can wipe away the return on investment if the investment is not done wisely. There are


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various investment options that are taxed highly. There are other investments for which the

returns are either not taxed or have a low tax. The individual has to understand the tax

laws of the land and invest accordingly to make high return on investment.

Avenues of investment:

Tax-saving bond

Tailored for investors with a low risk appetite, preservation of income is its primary goal.

Tax-saving bonds are issued by both public and private sector organisations.

Long-term infrastructure bonds are aimed at enhancing investments in infrastructureprojects in the country. With tenure of 10 years and a minimum lock-in period of five years,

these exhibit highest degree of safety. The yield on these bonds is between 7.5 and eightpercent, depending on the tenure and the type of bond product.

Depending on the applicable tax slab, individuals investing in tax-free infrastructure bonds

can benefit from a tax saving of Rs 2,000 to Rs 6,000 per annum, under Section 80CCF. Theinterest earned is taxable though.

Debt fund

Debt mutual funds are invested in a slew of debt instruments such as corporate bonds,government securities and money market instruments through income funds, gilt funds and

liquid funds. Compare the past performance and returns delivered before choosing a debtfund.

The returns carry a degree of uncertainty unlike other traditional debt products. If

redeemed within a year of investment, the returns are taxed at slab rates and beyond thatas long-term capital gains. Dividends earned are subjected to dividend distribution tax,

which is withheld by the fund house before dividend disbursement.

Public Provident Fund

The Public Provident Fund (PPF) is one of the most attractive investment options for play-safeinvestors, currently offering eight percent tax-free returns. A PPF account can be opened with

any nationalised bank or post office. Open only to resident Indian individuals, Rs 500 is the

minimum investment per year and Rs 70,000 is the maximum investment per year in a PPF

account.

An investment in PPF up to a ceiling of Rs 70,000 is also allowed as a deduction from

taxable income, under Section 80C.

Employee Provident Fund


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The salaried class typically invests in the Employee Provident Fund (EPF), as it is mandated.Generally, it is 12 percent of monthly basic salary. One can augment this and invest

additional money in their EPF account. This is called Voluntary Provident Fund (VPF).

There is no upper limit on the amount that can be invested in an EPF account per annum.Current returns on EPF are eight percent and the returns are tax-free. A deduction of up to

Rs 1 lakh is allowed under Section 80C.

Bank fixed deposits (FDs)

This is considered as a safe investment avenue. Certain 5-year FDs with Scheduled Banks

(Scheduled banks are those that are listed in the 2nd Schedule to the RBI Act. Most well known banksare scheduled banks) qualify for tax deduction. The interest rates vary from 7.5% per annum to 9% perannum. The interest rate is fixed in a sense that subsequent changes to the interest rates do not affectyou.

One major drawback of FDs is that interest is taxable. If you are in the highest tax bracket, the post taxreturn for you can be as less as 5% per annum.

National Savings Certificate (NSC)

This is also a very safe investment avenue. The certificate has a maturity period of 6 years. The currentinterest rate is 8.16% per annum. The interest rate is fixed in a sense that subsequent changes to theinterest rates do not affect you. That is, any increase/decrease in interest rates will not have any impacton your investment or interest earned.

If you invest Rs 100 in NSC, you will receive Rs 160 after 6 years assuming an interest rate of 8.16% perannum.

One major drawback of NSC is that interest is taxable. If you are in the highest tax bracket then the post-

tax return for you can be as less as 5.44% per annum instead of 8.16%.

NSCs can be purchased at any post office in your locality.

Section 80C also allows deduction on earned interest on NSC during the first five years. However, nodeduction on accrued interest is available in the year in which the NSC matures.

For instance, if you earn Rs 10,000 as interest in the sixth year then it will be taxed. Interest earnedduring the previous five years will be tax-free

Life insurance policy (including ULIP & pension plan)

There are a variety of insurance products available. The traditional plans such as money back, cash back,endowment, whole life, children plans are considered relatively safe. However, the returns thereon varybetween 4% per annum to 6% per annum. For most of these plans premium has to be paid monthly,quarterly, semi-annually or annually during the term of the policy.

The risk categorisation of ULIPs depends on the type of fund you opt for. The fund that invests its corpusmainly in equity (stocks) is considered riskier while the one investing chiefly in bonds/debentures(government debt akin to banks' fixed deposits) is considered relatively safer.


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The riskier funds offer potential for high returns while safe funds offer moderate returns.

Tax deduction can be claimed on the premium paid in respect of life insurance policy of self, spouse orchildren.

If the annual life insurance premium were more than 20% of the sum assured then the deduction would

be restricted to 20% of the sum assured. For example, if the sum assured is Rs 1,00,000 then only Rs20,000 will be available for tax deduction.

The death benefits of the life insurance policy are exempt from tax. If the annual insurance premium doesnot exceed 20% of the sum assured, the survival benefits are also exempt from tax under section 10(10D)of the Income Tax Act.

Generally, it is not a good idea to invest in insurance policies. Enough has already been written on thistopic and explains how the high selling, distribution and other expenses reduce the investor's returns.

Public Provident Fund (PPF)

PPF is considered yet another safe investment avenue. The current interest rate on PPF is 8% perannum. Again like EPF the rate of interest is not fixed. The government modifies the same from time totime.

The best part of PPF is that the interest thereon is exempt from tax under section 10(11) of the IncomeTax Act. Tax deduction can be claimed on contribution made by an individual into his own PPF account orinto the PPF account of his spouse or children.

PPF account can be opened in a nationalised bank or a post office. It is a 15-year account. The entireamount including accumulated interest can be withdrawn after 15 years.

Partial withdrawals (which are also tax free) are allowed from the 7th year. The minimum investmentamount is Rs 500 per financial year and the maximum is Rs 70,000 per financial year. The amount of

investment one can make may vary every year giving you a lot of flexibility in planning your investments.

Many of you may not like to invest in PPF due to its very long tenure (15 years). However, you may openan account and contribute only small sums initially; after all minimum annual contribution is just Rs 500. Inlater years, contributions can be increased.

Employees' Provident Fund

This is one of the very safe investment avenues. The current interest rate of EPF is 8.5% per annum.However, this rate is not fixed and the government can modify the same from time to time. The best partof EPF is that the interest earned is exempt from tax under section 10 (12) of the Income Tax Act. That isthe entire interest income earned by you goes into your pocket. The taxman gets nothing.

Investment in EPF can be made by way of a monthly contribution from your salary. The amountcontributed is 12% of the total of your basic salary and dearness allowance.

Over and above this 12%, some companies allow their employees, with certain ceilings (a certain amountabove which money can't be invested), to contribute an additional amount towards EPF. This is calledvoluntary provident fund (VPF). VPF is also eligible for tax deduction under section 80C.

You will be exempt from tax if withdrawals are done after a continuous contribution for 5 years or more,through one or more employers.


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However if you withdraw money before five years the entire interest portion and the employer'scontribution are taxable in the year of withdrawal. Portion of withdrawal which pertains to employee's owncontribution is not taxable.

One of problems with EPF investment is that you cannot make lump sum investment into the same. Theother problem is that at the time of withdrawal it often takes more than a few months to receive the money

from the PF trust.

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What Does Cash Conversion Cycle