Cash Collection Cycle

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Cash Collection Cycle

The cash cycle is a measure used to determine the number of days between when the business pays for its inventory and when it receives cash from its credit customers. Companies invest in inventory and other resources with an aim of selling them for cash and a profit. The cash collection period is used to determine how long cash is held up in inventory. When inventory is sold on credit, the ratio also captures how long it takes to collect cash from customers.

The cash cycle is computed as the sum of three activity ratios; days inventory outstanding, days sales outstanding and days payable outstanding. The days inventory outstanding is a reflection of the inventory currently held by the company and it shows how long it will take to convert the inventory into cash. It is calculated using the formula average inventory ÷ cost of goods sold per day. Days sales outstanding current sales and how long it will take to collect cash from customers. It is computed as average accounts receivable ÷ revenue per day. The days payable outstanding shows the outstanding payables that the company has. Payables are incurred when the company purchases inventory and on credit. The ratio is calculated as average accounts payable ÷ cost of goods sold per day (CI Staff, 2011).

The three ratios are added together to determine cash collection period. A smaller figure is preferred with negative figures being even more desirable. This is because getting small or negative CCC means that cash is tied up in inventory for shorter periods of time. The time between which inventory is bought, sold and cash received is small. A negative cash conversion cycle is the best measure that a company would want to achieve. This indicates that the company does not pay for its inventory until after the said inventory has been sold. Working capital is being efficiently utilized with the company having cash to settle other things. If the company has a negative of small cash conversion cycle, it should maintain it and avoid prolonging it.

Analysis of CVS Health Ratios

CVS had an inventory turnover rate of 10.34. This means that the company turned over inventory 10.34 times during the year. The company bought and cleared inventory an average of 10.34 times during the year. The production cycle was 35.31 times. In other words, the company took 10.34 days to sell the entire inventory held at any given time. The account receivable turnover rate was 14.76 times during the year. Finally, the average collection cycle is 24.73. This means that it took the company an average of 24.73 days to collect cash from customers who had purchased goods on credit.

Strategies to Increase Cash Flows

To increase cash flow in the business, the company can undertake the following strategies (SBDC, 2017)

i. Preparing cash flow projections

Preparing cash flow forecast will enable the company to have a good idea of their current cash flow level. It will also enable CVS to determine future cash flow needs and plan well in advance. This way, in case the business is likely to run out of cash, it can always cover cash flow needs through borrowing.

ii. Evaluation of terms

To boost cash collection from customers, CVS may evaluate collection policy. This may involve offering discounts to customers if they pay within a short period of time, this way, debtors will be motivated to settle their accounts quickly to take advantage of the discounts. Similarly, CVS also purchases goods on credit and is most likely offered discounts if they settle their accounts within a given period. They should therefore take advantage of these discounts to reduce the overall payable.

iii. Improvement of inventory

Excess inventory results in the company incurring unnecessary inventory holding costs. To avoid incurring these costs, the company should use strategies to determine optimal inventory level. This will free up cash that would have otherwise been held inventory.

iv. Sending invoices promptly

When customers are reminded to settle their accounts soon, they tend to pay up more quickly. Delays in sending invoices may mean that receivables are settled slowly.

v. Conducting credit checks on customers

This minimizes the possibility of incurring bad debts from customers with poor credit rating. Also, customers with high credit rating tend to settle their accounts more quickly thus increasing cash flow.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References

CI Staff (2011). The cash conversion cycle. Retrieved 22 May 2017, from https://www.aaii.com/computerized-investing/article/the-cash-conversion-cycle.touch

SBDC (2017). Strategies for Improving Your Cash Flow – America’s SBDC – California / Los Angeles Network. (2017). America’s SBDC – California / Los Angeles Network. Retrieved 22 May 2017, from https://smallbizla.org/10-tips/strategies-for-improving-your-cash-flow/