2.9 Measures of corporate liquidity
2.9.2 The dynamic view
The dynamic view was developed in order to address the weaknesses of the static approach to liquidity analysis. This view tries to measure the firm’s liquidity position from a time perspective by linking the balance sheet and the income statement. It includes measures like the Cash Conversion Cycle and the Net Trade Cycle.
2.9.2.1 The Cash Conversion Cycle
Gitman (1974) developed the Total Cash Cycle (TCC) and defined it as the time interval between cash flows out of the business in order to produce goods or services and the cash received from the sale of those goods. Gitman and Sachdeva (1984) later refined the TCC and produced the Cash Conversion Cycle (CCC). The CCC combines information from the balance sheet and income statement to produce a measure that focuses on the net time interval between payment and receipt of cash flows (Uyar, 2009, Richards and Laughlin, 1980). It is considered an ongoing liquidity measure because it gives the time interval between payment for raw materials and collections from customers (Deloof, 2003, Padachi, 2006, Emery, 1987). The CCC recognizes that the main operations of the firm relating to liquidity management; procuring goods for production or sale, paying suppliers for those goods, selling the goods and collecting from customers are not fulfilled instantaneously and synchronically (Wang, 2002). Another advantage of the CCC in liquidity analysis is that it enables the firm to segregate working capital management efficiency into three distinct areas, payables period, inventory period and receivables period. The payables period and the receivables period, respectively measure the firm’s efficiency in upstream and downstream supply chain management, while the inventory period measures its production or sales efficiency. The disaggregation of working capital management efficiency into these three key areas makes it easy for the firm to identify problematic areas when analysing liquidity management problems. The cash conversion cycle is illustrated diagrammatically in Figure 1.
32 The Cash Conversion Cycle is calculated as:
Cash Conversion Cycle = Receivables Period + Inventory Period – Payables Period.
Receivables Period = (accounts receivable / sales) × 365 Inventory Period = (inventories / cost of sales) × 365 Payables period = (accounts payable / purchases) × 365
Cash Conversion Cycle = (Accounts receivable
Sales × 365) + ( Inventory
Cost of Sales × 365 ) – (Accounts payable
Purchases × 365 )
FIGURE 1: THE OPERATING AND CASH CYCLE
Inventory purchased Inventory sold
Inventory period Accounts receivable period
Accounts Payable Cash Cycle
Cash paid for inventory Cash received
Operating cycle Source: Adapted from Firer et al. (2012) p. 555
The operating cycle is the time between the acquisition of inventory, the processing of the inventory, selling the inventory as a finished product and collection for the sale. The operating cycle is calculated as follows:
Operating Cycle = (Accounts receivable
Sales × 365) + (Inventory
Cost of Sales × 365 )
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The cash cycle shows that there is a time lag between paying suppliers for merchandise and collection from customers for sales made. The cash cycle is calculated as follows:
Cash Cycle = Operating Cycle − (Accounts payable
Purchases × 365 )
The cash cycle increases as the inventory period (taking too long to turn over the inventory) and receivables period (taking too long to collect from customers following the sale) lengthen. The cash cycle decreases when the firm is able to increase the payables period (delay settling its payments to suppliers). An increasing cash cycle can be an indication of obsolete inventory or difficulties in collecting from customers (Firer et al., 2012). A long cash cycle reduces the total asset turnover (TAT) because the firm would be taking too long to turn over its current assets to generate sales and the reduction in TAT may lead to a decrease in profitability as measured by return on equity (ROE).
Total Asset Turnover = Sales Total Assets
Return on Equity = Net Profit Margin × Total Asset Turnover × Equity Multiplier Where Net Profit Margin =Net Profit After Tax
Sales and Equity Multiplier = Total Assets Total Equity
The decline in both TAT and ROE may also cause a drop in the firm’s sustainable growth rate (SGR).
Sustainable Growth Rate (SGR) = Return on Equity × bo
Where 𝑏𝑜 is the retention ratio (the proportion of the firm’s profits that is ploughed back) and ROE measures the return on shareholders’ funds in an accounting period and is calculated as follows:
Return on Equity =Net Profit after Tax Total equity
The goal of the firm should be to minimise its CCC because it indicates efficiency in managing its cash flows and reduces the amount of working capital investment. This requires analysing and
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taking steps to ameliorate each element of the CCC. However, improving the CCC should be undertaken with caution in order to ensure that it is not achieved at the expense of operational efficiency, depressing sales and denting the firm’s reputation with suppliers. Delaying payments to suppliers beyond the agreed terms may lead to a decline in the firm’s credit rating with suppliers, while strict credit terms may cause customers to purchase such goods where they consider credit terms to be more favourable.
Gentry et al. (1990) criticised the CCC because its focus is on the duration funds are tied up in the firm’s operating cycle and it does not adequately consider the amount of funds invested in the product. They designed an adjusted version of the CCC which they called the Weighted Cash Conversion Cycle (WCCC). The Weighted Cash Conversion Cycle “weights the turnover time of a specific component by considering the portion of the total cash tied up in that component”
(Erasmus, 2010) p.3.
The main limitation of the WCCC is that much of the information required for its calculation is not available to researchers, such as the breaking-up of inventory components into raw materials, work-in-progress and finished products (Shin and Soenen, 1998).
In a critique of the CCC, Kiernan (1999) cited the following three weaknesses of the model: 1) its failure to distinctly translate the cash conversion period or days to working capital needs in Rand or Dollar value terms; 2) its failure to distinguish between cash sales and credit sales; and 3) its failure to show the impact of profitability on liquidity. The CCC’s failure to distinguish between cash sales and credit sales presents a major limitation of this method. For example, it means that if two firms have the same debtors’ period but different credit sales/total sales ratios, ceteris paribus, such firms would have the same CCC. However, from a liquidity point of view, the firm with the higher cash sales/total sales ratio has better capacity to meet maturing obligations because most of its sales are collected sooner and with much more certainty. By focusing on the difference in timing between the point that the firm spends resources in order to generate revenue and the actual receipt of that revenue, the model fails to recognise that
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the received revenue will exceed the expenditure by the amount of the profit earned. The profit earned contributes to the improvement of the overall liquidity of the firm because profit represents additional resources available to meet obligations.
The views of Kiernan (1999) on CCC and profitability relationship the hold some water.
However, it is worth mentioning that several studies have used the CCC as a proxy for working capital management efficiency when examining the impact of working capital management on profitability. Previous studies (Deloof, 2003, García-Teruel and Martínez-Solano, 2007, Shin and Soenen, 1998, Jose et al., 1996) have generally found a negative relationship between a firm’s profitability and the CCC which has been interpreted to mean that more profitable firms invest less in working capital.
Despite the noted limitations of the cash conversion period model, it remains a powerful tool to assess working capital management efficiency and assists in predicting financial bankruptcy.
Shin and Soenen (1998) cite the example of Wal-Mart and Kmart. In 1994, their capital structures were similar and the CCC of Wal-Mart and Kmart were 40 days and 61 days, respectively. As a result of its longer CCC, Kmart likely faced additional financing costs of US$
198.3 million per year, which was an unsustainable situation that eventually contributed to its bankruptcy.
2.9.2.2 The Net Trade Cycle
Shin and Soenen (1998) questioned the suitability of the CCC to measure corporate working capital management efficiency on the grounds that its calculation involves the addition of ratios with different denominations. Consequently the Net Trade Cycle (NTC) was developed. The NTC is similar to the CCC except that the three elements are all expressed as a percentage of sales.
The NTC is calculated as follows:
Net Trade Cycle = Receivables Period + Inventory Period – Payables Period.
Receivables Period = (accounts receivable / sales) × 365
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Inventory Period = (inventories / sales) × 365 Payables period = (accounts payable / sales) × 365
Net Trade Cycle = (Accounts receivable
Sales ˟ 365) + (Inventory
Sales ˟ 365 ) – (Accounts payable Sales ˟ 365 )
The NTC measures the number of “days’ sales” the firm has to pay for its working capital. It is an easy method of calculating additional financial resources with regard to working capital expressed as a percentage of the forecast sales growth (Shin and Soenen, 1998). The NTC is closely linked with the shareholder value creation objective of the firm. A shorter NTC is an indication of working capital management efficiency, reduces the demand for external funding and generates improved financial performance, which leads to a higher present value of net cash flows and higher shareholder value creation.