Entrepreneurship, Second Edition

11.2. Cash Conversion Cycle

One of the most important considerations in setting up a business is deciding when to pay the bills.

The business operating cycle for a traditional manufacturer begins with the purchase of raw materials and ends with collections from the customer. It includes three key components: the inventory cycle, the accounts receivable cycle, and the accounts payable cycle. The inventory cycle begins with the purchase of the raw materials, includes the work-in-process period, and ends with the sale of the finished goods. The accounts receivable cycle then begins with the sale and concludes with the collection of the receivable. During this operating cycle, the business generally receives some credit from suppliers.

The accounts payable cycle begins with the purchase of the raw materials or finished goods, but it ends with the payment to the supplier. The vast majority of organizations, particularly manufacturing operations, experience a gap between the time when they have to pay suppliers and the time when they receive payment from customers. This gap is known as the cash conversion cycle (CCC). For most companies, the credit provided by suppliers ends long before the accounts receivables are paid. This means that, as companies grow sales levels, they need to get external financing to fund working capital needs. One of the primary causes of bankruptcy is the inability to finance operations, shutting down potentially successful ventures.

Some companies generate ...