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The Daily Technical #63: Why is the income statement insufficient to assess the liquidity of a company?

How to answer "What is the cash conversion cycle?"

December 06, 2024

Good morning. Welcome to the 63rd edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
What is the cash conversion cycle?

The cash conversion cycle ("CCC") measures the number of days it takes a company to convert its inventory into cash from sales.

A lower cash conversion cycle is preferred as it implies the company generates and collects cash over a shorter duration.

As a general rule, companies with lower CCCs operate efficiently, hold more negotiating power over suppliers, and have quicker sales collection cycles.

Cash Conversion Cycle = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)

Common Mistakes

  1. Overlooking the fact that a 'good' cash conversion cycle can vary significantly across industries. Avoid assuming that a universally low CCC is beneficial for all businesses.

  2. Focusing solely on the operational implications of the CCC. Avoid this by discussing how a long CCC might necessitate more working capital, possibly affecting a company’s financing needs or mandates on securing external funds.

TL;DR

  • The Cash Conversion Cycle (CCC) measures days taken to convert inventory to cash from sales.

  • CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) - Days Payable Outstanding (DPO).

  • Shorter CCC is preferred; indicates efficient operations and quicker cash collection.

TODAY’S QUESTION
Why is the income statement insufficient to assess the liquidity of a company?

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THAT’S A WRAP
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