EN.662.611 Chap.5 Short-Term Liabilities and the Cash Conversion Cycle
Short-Term Liabilities and the Cash Conversion Cycle
Matching financing to what it pays for
The second Week 4 lecture begins with the financing mix. Short-term assets such as inventory should be financed with short-term liabilities such as accounts payable, and long-term assets with long-term debt.
Whether a company has borrowed more than it can afford is tested with working capital and liquidity ratios for short-term debt and with debt service ratios for long-term debt.
Working capital and the cash conversion cycle
Working capital is current assets minus current liabilities, stated in dollars; the lecture describes it as unproductive because the cash is tied up.
The cash conversion cycle turns the same idea into days: days in inventory plus days sales outstanding minus the average payment period. It answers how long the company is out of pocket between paying suppliers and collecting from customers.
The goal is a cycle as short as possible, even zero or negative, by holding less inventory, collecting faster and paying suppliers later.
Liquidity ratios and their benchmarks
Accounts payable turnover divides cost of goods sold by average payables, and the average payment period is 365 divided by that turnover.
The current ratio compares current assets with current liabilities against a benchmark of 2. The quick ratio is more conservative: it counts only cash, receivables and marketable securities, against a benchmark of 1.
Liabilities that depend on events or on payroll
A contingent liability such as a lawsuit is recorded when a loss is probable and can be reasonably estimated, at the low end of any range; otherwise it is disclosed in the notes.
Payroll creates liabilities because the employer acts as a collection agent for income taxes and for Social Security and Medicare, and adds its own matching contributions.
From days to dollars
A change in the cycle is easier to judge when it is converted into cash.
Multiply the days saved on receivables by a day of sales, and the days saved on inventory or gained on payables by a day of cost of goods sold, to estimate how much cash was released. That figure lets an analyst say whether working capital management moved the company's cash position by a trivial or a material amount, and whether the gain came from customers, stock or suppliers.
What this chapter covers
- 01
Matching short-term and long-term financing
- 02
Working capital in dollars
- 03
Days in inventory, DSO and the average payment period
- 04
The cash conversion cycle and its levers
- 05
Current and quick ratios
- 06
Contingent liabilities
- 07
Payroll liabilities
Worked example · free
Compute a cash conversion cycle
- 1DSO: 365 times $60,000 divided by $730,000 is 30 days.
- 1Days in inventory: 365 times $72,000 divided by $438,000 is 60 days.
- 1Average payment period: 365 times $36,000 divided by $438,000 is 30 days.
- 1Cycle: 60 plus 30 minus 30 is 60 days.
Key terms
- Working Capital
- Current assets minus current liabilities, measured in dollars rather than as a ratio.
- Average Payment Period
- The average number of days a company takes to pay suppliers: 365 divided by payables turnover.
- Quick Ratio
- Cash, receivables and marketable securities divided by current liabilities; the course benchmark is 1.
- Contingent Liability
- A possible obligation, such as a lawsuit, recorded when a loss is probable and reasonably estimable.
Short-Term Liabilities and the Cash Conversion Cycle FAQ
Why is the payment period subtracted in the cycle?
While a supplier waits to be paid, it is effectively financing the company's inventory. Those days reduce the time the company must fund itself, so they shorten the cycle rather than lengthen it.
Can the cash conversion cycle be negative?
Yes. If customers pay before suppliers must be paid, the company collects cash before it spends it. The lecture treats a cycle near zero or below as the goal.
What happens to a lawsuit that is only reasonably possible?
It is not recorded as a liability. When a loss is not probable or cannot be reasonably estimated, the company discloses the matter in the notes to its statements instead.
Exam move
Compute the three day counts for two years of one company, explain each change in a sentence, and then test what one lever, such as longer supplier terms, would do to the cycle and to the current and quick ratios.
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