Cash Flow, and the Cash Conversion Cycle
Free cash flow is one measure of the financial health of a company. Free cash flow is a measure of the amount a company is able to generate after cas expenditures necessary to sustain the company's operations. Free cash flow is calculated using this simple formula:
FCF = Operating Cash Flow [from the Statement of Cash Flows] - Capital Expenditures.
The cash conversion cycle is the number of days it takes a company from its outlay of cash to purchase inventory or raw materials to the time it converts either inventory into cash or accounts receivable into cash. The goal of any company extending credit is to reduce the cycle time for collecting accounts receivable. Thus, cycle time reduction in A/R is the process associated with accelerating collections and reducing DSO.
This has two applications for the typical credit department. The first is looking at customers cash conversion cycles as a way to evaluate whether it is likely the company under review will have the cash on hand to pay invoices as they come due. The second application involves the credit department's role in its company in shortening the cash conversion cycle by reducing DSO or the time required to convert accounts receivable into cash. The cash conversion cycle involves a continuous process of turning inventory into accounts receivable, and converting accounts receivable into cash.
© 2010 by Michael C. Dennis. All Rights Reserved.