Final answer:
The cash conversion cycle refers to the period between purchasing raw materials and receiving payment from customers for sales. It includes inventory management, sales, and accounts receivable collection. A shorter cycle is usually desirable for better financial efficiency.
Step-by-step explanation:
The cash conversion cycle refers to the length of time from the cash payment for the purchase of raw materials until the collection of accounts receivable associated with the sale of the manufactured product. This metric is key for understanding how efficiently a company manages its working capital and liquidity. It encompasses three primary components: the inventory conversion period, the receivables collection period, and the payables deferral period.
The cycle starts when a company pays cash to purchase raw materials. It continues as these materials are converted into finished products, the products are sold, and the company waits to receive payment from customers. The cycle completes when the cash from sales is collected. Companies aim to shorten the cash conversion cycle to enhance their liquidity and reduce the need for external financing.
It is the time it takes for the company to convert its cash investment into raw materials, labor, and manufacturing processes, and finally, collect cash following a sale of inventory.
For example, if a company takes 30 days to pay for raw materials, 40 days to manufacture and sell the product, and then collects cash in 20 days, the cash conversion cycle would be 90 days (30 + 40 + 20 = 90).