An Optimal Cash Conversion Cycle

International Research Journal of Finance and Economics
ISSN 1450-2887 Issue 120 March, 2014

http://www.internationalresearchjournaloffinanceandeconomics.com
An Optimal Cash Conversion Cycle
Haitham Nobanee
College of Business Administration, Abu Dhabi University
P.O. Box 59911, Abu Dhabi, United Arab Emirates
E-mail: nobanee@gmail.com
Tel: +971 2 5015709; Fax: +971 2 5860184
Maryam AlHajjar
College of Business Administration, Abu Dhabi University
P.O. Box 59911, Abu Dhabi, United Arab Emirates
E-mail: maryam.hajjar@gmail.com
Tel: +971 2 5015709; Fax: +971 2 5860184
Abstract
Although the operating cycle, the cash conversion cycle and the net trade cycle are
more comprehensive measures of working capital management compared with traditional
measures such as the current ratio and the quick ratio, these measures do not consider the
optimal points of payables, inventory, and receivables. In this study we suggest more
accurate measures of the efficacy of working capital management where optimal levels of
inventory, receivables, and payables are identified, and total holding and opportunity costs
are minimized. In this paper, we suggest an optimal operating cycle, an optimal cash
conversion cycle, and an optimal net trade cycle as more accurate and comprehensive
measures of working capital management.
Keywords: Working Capital Management; Optimal Cash Conversion Cycle; Optimal Net
Trade Cycle; Optimal Operating Cycle; Profitability
1. Introduction
Historical experience shows that an average firm has 40% of its assets employed in current assets, and
the typical corporate financial manager spends 80% of her/his time in managing day-to-day short term
financial resources (Dandapani, et al, 1993). Yet, the traditional focus in corporate finance had been on
long-term financial decisions, particularly capital structure, dividends, investments, and company
valuation decisions. However, the recent trend in corporate finance is the focus on working capital
management (Ganesan, 2007). Some of the existing literature suggests that companies, on average,
over-invest in working capital. For example, U.S. corporations had roughly $460 billion unnecessarily
tied up in working capital (Moussawi et al, 2006).
The basic elements of working capital management are based on speeding up collections and
slowing down disbursements (Nobanee et al, 2011). This working capital management principle is
based on the traditional concepts of the operating cycle, the cash conversion cycle, the weighted cash
conversion cycle and the net trade cycle. The operating cycle of a firm is the length of time between
the acquisition of raw materials and the collections of receivables associated with the sales of finished
goods. Although the operating cycle considers the financial flows coming from receivables and
inventory, it ignores the financial flows coming from account payables. In this regard, Richards and
International Research Journal of Finance and Economics - Issue 120 (2014) 14
Loughlin (1980) suggest a cash conversion cycle that considers all relevant cash flows coming from
operations. The cash conversion cycle can be defined as the length of time between cash payments for
purchase of raw materials and the collection of receivables associated with the sale of finished goods.
However, the cash conversion cycle focuses only on the length of time of financial flows engaged in
the cycle and does not consider the amount of funds committed to a product as it moves through the
cash conversion cycle. Therefore, Gentry, Vaidyanathan, and Wai (1990) suggest a weighted cash
conversion cycle that takes into consideration both the timing of financial flows and the amount of
funds committed to each stage of the cycle. The weighted cash conversion cycle can be defined as the
weighted number of days funds are committed in receivables, inventories and payables, less the
weighted number of days financial flows are deferred to suppliers. In addition to its complexity, one
limitation of the weighted cash conversion cycle is the break-up of inventory into three components:
raw materials, work in process, and finished goods is not always available for outside investigators;
hence, Shin and Soenen (1998) suggest the net trade cycle as an alternative measure for working
capital management. They argue that the cash conversion cycle is an additive concept wheareas the
denominators for the inventory conversion period, the receivable collection period, and the payable
deferral period are all different, making the addition of the cash conversion cycle components not
really useful. They suggest equalizing the denominators of the inventory conversion period, the
receivable collection period, and the payable deferral periods1. The net trade cycle is basically equal to
the cash conversion cycle where the three components of the cash conversion cycle (receivables,
inventory, and payables) are articulated as a percentage of sales. This makes the net trade cycle easier
to calculate and less complex compared with the cash conversion cycle and the weighted cash
conversion cycle. Shin and Soenen (1998) also argue that the net trade cycle is a better working capital
efficiency measure compared with the cash conversion cycle and the weighted cash conversion cycle
because it indicates the number of "day sales" the company has to finance its working capital and the
working capital manager can easily estimate the financing needs of working capital expressed as a
function of the expected sales growth.
Although the operating cycle, the cash conversion cycle, the weighted cash conversion cycle
and the net trade cycle are powerful measures of working capital management in contrast to the static
traditional ratios such as the current ratio and the quick ratio that are inadequate and misleading in the
evaluation of the firm's liquidity, these cycles do not consider the optimal levels of receivables,
inventories, and payables. The traditional link between these cycles (the operating cycle, the cash
conversion cycle, the weighted cash conversion cycle and the net trade cycle) and the firm's
profitability, market value and liquidity is that shortening these cycles increases the firm’s profitability,
liquidity, and market value (see, Shin and Soenen, 1998; Gentry, et al, 1990; Richards and Loughlin,
1980, Deloof, 2003). Fore example; a short cash conversion cycle indicates that the company manages
and processes inventory more quickly, collects cash from receivables more quickly and slows down
cash payments to suppliers. This increases the efficiency of the internal operations of a firm and results
in higher profitability, higher net present value of cash flows, and higher market value of a firm
(Gentry, et al, 1990).
The cash conversion cycle and the net trade cycle can be shortened by reducing the time that
cash is tied up in working capital. This could happen by shortening the inventory conversion period via
processing and selling goods to customers more quickly, or by shortening the receivable collection
period via speeding up collections, or by lengthening the payable deferral period via slowing down
payments to suppliers. On the other hand, shortening the cash conversion cycle could harm the firm's
profitability; reducing the inventory conversion period could increase the shortage cost, reducing the
receivable collection periods could make the company losing its good credit customers, and
lengthening the payable period could damage the firm's credit reputation. A shorter cash conversion
1
The cash conversion cycle formula is: (accounts receivables/sales)*365 +(inventory/CGS)*365 – (accounts
payables/CGS)*365
The net trade cycle formula is :{accounts receivable + inventory – accounts payables}*365/sales
15 International Research Journal of Finance and Economics - Issue 120 (2014)
cycle (net trade cycle and operating cycle) is associated with a high opportunity cost, and a longer cash
conversion cycle (net trade cycle and operating cycle) is associated with a high carrying cost.
1.1. Optimal Operating Cycle

The optimal operating cycle is an additive function. It measures the optimal length of inventory conversion
period plus the optimal length of receivables collection period (see equation 1 and 2) bellow:
Optimal Operating Cycle = Optimal Inventory Conversion Period + Optimal Receivables
Collection Period (1)
Optimal Operating Cycle = (Optimal Inventory/Cost of Goods Sold)*365 + (Optimal
Receivables/ Sales)*365 (2)
1.2. Optimal Cash Conversion Cycle

The optimal cash conversion cycle is an additive function. It measures the optimal length of the
inventory conversion period plus the optimal length of the receivables collection period less the
optimal length of payables deferral period (see equation 3 and 4) bellow:
Optimal Cash Conversion Cycle = Optimal Inventory Conversion Period + Optimal
Receivables Collection Period – Optimal Payable Deferral Period (3)
Optimal Cash Conversion Cycle = (Optimal Inventory/Cost of Goods Sold)*365 + (Optimal
Receivables/ Sales)*365 – (Optimal Payables/Cost of Goods sold)*365 (4)
1.3. Optimal Net Trade Cycle

The optimal net trade cycle is also an additive function. It measures the optimal length of inventory
conversion period plus the optimal length of receivables collection period less the optimal length of
payables deferral period, the optimal inventory conversion period and optimal length of payable
deferral period are expressed in a day’s sales. (see equation 5, 6 and 7 below:
Optimal Net Trade Cycle = Optimal Inventory Conversion Period + Optimal Receivables
Collection Period – Optimal Payables Deferral Period (5)
Optimal Net Trade Cycle = (Optimal Inventory/Sales)*365 + (Optimal Receivables/
Sales)*365 – (Optimal Payables/Sales)*365 (6)
Or
Optimal Net Trade Cycle = {(Optimal Inventory + Optimal Receivables - Optimal
Payables)*365}/Sales (7)
1.4. Optimal Inventory Level

One of the best-known optimal inventory level approaches is the Economic Order Quantity model
(EOQ)2 (see Ross et al, 2008). The basic idea of this model is plotting the total cost of carrying
inventory with different inventory quantities as in Figure 1. As shown in Figure 1 below, inventory
carrying costs increase and inventory shortage costs decrease as inventory levels increase and we
attempt to identify the minimum total cost point Q*.
2
There are many ways to find the optimal inventory level, in addition to the classic EOQ model. Optimal inventory
level could be identified using Shortages Permitted Model, Production and Consumption Model, Production and
Consumption with Shortages Model , and EOQ with Shortages and Lead Time. Moreover, there are many other new
optimal inventory models developed in the recent literature, such as the EOQ model under retailer trade credit policy
suggested by Huang and Hsu (2008). This model identifies the optimal inventory level under permissible delay in
payments where the supplier would offer the retailer trade credit and the retailer would also offer a trade credit to her/
his clients.
Figure 1: Optimal Inventory Level
1.5. Optimal Accounts Receivable

An optimal credit amount could be identified by the point where the incremental cash flows from
increased sales stimulated by offering credit to the customers equals the costs of carrying additional
investments in account receivables (Ross et al, 2008). Therefore, an optimal amount of credit extended
could be identified by plotting the total cost of granting a credit with different amounts of credit
extended as in Figure 2.
Figure 2: Optimal Receivables
Source: Ross, Westerfield, and Jordan, 2008, Corporate Finance Fundamentals, Eighth's Edition, McGraw Hill. Carrying
costs are increased when the amount of receivables granted are increased. Opportunity costs are the lost sales
resulting from not granting credit. These costs decreased when the amount of receivables are increased. Total
costs are the sum of currying and opportunity costs
As shown in Figure 2, carrying costs increase and opportunity costs decrease as the amount of
credit extended increases. We attempt to identify the minimum total cost point $*. The carrying costs
associated with granting a credit essentially come from either the costs of cash discounts offered by the
firm who grant the credit to its customers who pay early, or it could come from losses of bad debts, or
it could be associated with managing credit or credit collections or running the credit department.
Opportunity cost is the additional profit that results from credit sales that are lost because credit is not
granted (Ross et al, 2008)3.
1.6. Optimal Accounts Payable

Trade credit is an alternative financing choice to the short-term borrowing. While trade credit is “free”,
short-term borrowing is “costly”. When a company extends its trade credit by increasing its accounts
payables it saves the cost of short-term borrowing. This means an increase of accounts payable is
associated with a decrease of short-term borrowing cost or “opportunity cost of short-term borrowing”.
When the accounts payable increases, some other kind of cost also increases. For example, the carrying
cost which is the cost of managing and running the payable department increases as the account
payable increases. Other costs could also increase when payable increases accounts. For example, the
possibility that a company could delay its payment to suppliers increases when the company extends its
trade credit. This could damage the company’s credit reputation and it could lose some of the cash
discounts offered by its suppliers.
As shown in Figure 3, carrying costs increase and opportunity costs of short-term borrowing decrease
as accounts payable amount increases. We attempt to identify the minimum total cost point $*4.
Figure 3: Optimal Payables
Total Costs
Cost of Payables
Carrying Costs
Opportunity Cost
of Short-Term
Borrowing
$* Amount of Payables
Optimal Amount of Payables
Carrying costs and delay of payments costs increase when the amount of payables increases.
Opportunity costs of borrowing decreases when the amounts of payables increase.
Total costs are the sum of carrying and opportunity costs.
2. Data and Methodology

We examine the relationship between the cash conversion cycle and profitability for the full sample
period of 1990-2004 and for subsample periods. We hypothesize that the coefficients of the cash
conversion cycle are negative and significant for the full period and for all sub periods. This indicates
that the company manages and processes inventory more quickly, collects cash from receivables more
quickly and slows down cash payments to suppliers. This increases the efficiency of the internal
operations of a firm and results in higher profitability. In contrast, if the coefficients of the cash
3
Although many optimal amounts of credit are easy to identify, they are difficult to quantify as pointed out by Ross et
al, (2008). There were some attempts to quantify the optimal amount of credit as in the study of Liebman (1972).
4 There were also some attempts to quantify the optimal amount of payables by Nerville and Tavis, (1973).
conversion cycle in the full periods or the sub periods are significant and positive, this indicate that
shortening the cash conversion cycle could harm the firm's profitability because reducing the inventory
conversion period could increase the shortage cost, reducing the receivable collection periods could
lead to the company’s loss of good credit customers, and lengthening the payable period could damage
the firm's credit reputation. We apply a similar analysis for the net trade cycle and the operating cycle.
If the coefficients of the cash conversion cycle, the net trade cycle and the operating cycle are not
significant and negative in all study periods, this signifies the importance of identifying the optimal
cash conversion cycle, the optimal net trade cycle and the optimal operating cycle as more accurate
measures of working capital management. A dynamic panel data analysis is used to test for the
relationships between our variables. Our analysis is based on a sample of 5802 U.S. non-financial firms
listed in the New York Stock Exchange, American Stock Exchange, NASDAQ Stock Market and the
Over The Counter Market for the period 1990-2004 (87030 firm-year observations).
To examine the relationships between our study variables we employ a Generalized Method of
Moment System Estimation (GMM) applied to dynamic panel data proposed by Arellano and Bover (1995)
and Blundell and Bond (1998). This estimation approach leads to the following estimation equations:
oisit = α + β1 oisit + β 2 qrit + β 3 tdeit + β 4 sg it + β 5 rcpit + β 6 icp + β 7 pdpit + β 8 cccit + ε it
−1 it
(8)
oisit = α + β1 oisit−1 + β 2 qrit + β 3 tdeit + β 4 sg it + β 5 rcpit + β 6 icpit + β 7 pdpit + β 8 nccit + ε it (9)
oisit = α + β1 oisit−1 + β 2 qrit + β 3 tdeit + β 4 sg it + β 5 rcpit + β 6 icpit + β 8 ocit−1 + ε it (10)
Where ( oisit ) is the first deference the operating income to sales, the exploratory variables in
our model includes ( oisit ) which is the differenced lagged dependent variable of operating income to
sales, ( rcpit ) is the first difference of receivable collection period that measures the average number of
days from the sale of goods to collection of resulting receivables. It is calculated as [(account
receivable/sales) *365]. ( icpit ) is the first difference of the inventory conversion period which is the
length of time on average needed to convert raw materials into finished goods and for the sale of these
goods. It is calculated as [(inventory/cost of good sold)*365]. ( pdpit ) is the first difference of the
payable deferral period which is the average length of time needed to purchase goods and the payments
made for them. It is calculated as [(account payable/cost of goods sold)* 365]. ( cccit ) is the first
difference of the cash conversion cycle which is calculated as [Receivable collection period +
Inventory conversion period - Payable deferral period]. ( nccit ) is the first difference of the net trade
cycle which is calculated as [Receivable collection period + Inventory conversion period - Payable
deferral period] where inventory conversion period and payable deferral period are expressed in the
form of day’s sales. ( ocit ) is the first difference of the operating cycle which is simply calculated as
[Receivable collection period + Inventory conversion period]. The exploratory variables in our models
also include some control variables such as ( sg it ), which represents sales growth [(this year’s sales –
previous year’s sales)/ previous year’s sales] and total debt to equity ratio ( tdeit ). In addition, we
examine the relationship between profitability and liquidity using a traditional measure of liquidity -
the quick ratio ( qrit ). In this study we hypothesize that shortening the length of the cash conversion
cycle improves the company’s performance. We also hypothesize that shortening the length of the net
trade cycle improves the company’s performance, and shortening the length of the operating cycle
improves the company’s performance. This means that the coefficient of the cash conversion cycle, the
coefficient of the net trade cycle, and the coefficient of the operating cycle should be significant and
negative for the whole period of the study and also for the sub periods. We also hypothesis that
shortening the length of the receivable collection period increases the company’s performance, and we
expect the coefficient of the receivables collection period to be significant and negative for the whole
period of the study and also for the sub periods. Further, we hypothesize that shortening the length of
the inventory conversion period increases the company’s performance, and we expect the coefficient of
the inventory conversion period to be significant and negative for the whole period of the study and
also for the sub periods. Finally, we hypothesize that lengthening the payable deferral period should
increase the company's performance, and the coefficient of the payable deferral period should be
significant and positive for the full study period and also for the sub periods.
3. Empirical Results
In this section we present our estimation results concerning the factors of working capital management
affecting corporate performance. The estimated coefficients based on equation (8) reported in table (1)
show that the length of the cash conversion cycle ( cccit ) has a negative and significant impact on the
firm’s performance for the whole period. The results also show that the coefficient of the cash
conversion cycle for the first period is positive and insignificant, that it is positive and insignificant for
the second period, and it is negative and significant for the third period. These results indicate that
shortening the cash conversion cycle does not always improve the firm’s profitability. The results also
show that the coefficients of the payable deferral period ( pdpit ) for the whole period and all sub
periods of the study are significant and negative; this indicates that lengthening the payable deferral
periods reduces the firm’s performance instead of improving it. The results reported in table (1) show
that the coefficients of the receivables collection period ( rcpit−1 ) and the length of the inventory
conversion period ( icpit−1 ) had a positive rather than a negative impact on the company’s performance
measured using the operating income to sales ( oisit ). This indicates that shortening the cash conversion
cycle ( cccit−1 ) shortening the receivable collection period ( rcpit−1 ) and shortening the inventory
conversion period ( icpit−1 ) by reducing the time that cash is tied up in working capital and by speeding
up collections results in lower operating income to sales ( oisit ). However, the results in the existing
literature show that the cash conversion cycle ( cccit−1 ), the receivable collection period ( rcpit−1 ), and
the inventory conversion period ( icpit−1 ) had a negative impact on the company's performance ( oisit )
(Deloof, 2003). The positive sign of the coefficient of the inventory conversion period ( icpit−1 )
indicates that shortening the inventory conversion period ( icpit−1 ) could increase the stock out cost (or
shortage cost) of inventory which results in losing sales opportunities and leads to poor performance.
Similarly, the positive sign of coefficient of the receivable collection period ( rcpit−1 ) indicates that
shortening the receivable collection period ( rcpit−1 ) makes the company to lose its good credit
customers that results in a reduction in the company’s sales. The results also show that the payable
deferral period ( pdpit−1 ) had a significant negative impact on performance ( oisit ) instead of having a
positive impact as reported in the existing literature (Deloof, 2003). The negative sign of the payable
deferral period ( pdpit−1 ) implies that slowing down payments to suppliers causes damage to the
company’s credit reputation and results in a poor performance. The lagged operating income to sales (
oisit−1 ) indicates that the company's performance in the previous period has a strong positive effect on
its performance in the current period. We also examine whether the company’s performance is affected
by other variables; the results show that an increase in the quick ratio ( qrit ) is negatively associated
with the firm’s performance ( oisit ). This result certifies the traditional trade-off between profitability
and liquidity. Sales growth ( sg it ) is positively related to the firm’s performance ( oisit ). The results
show that total debt to equity ( tdeit ), as a measure of capital structure, is not significantly related to
profitability ( oisit ). The results of the Sargan test does not reject our instrument used, and the results of
Arellano-Bond test that the average autocoveriance in residuals of order 1 and 2 is 0 which does not
reject the null hypothesis of no second-order serial correlation.
Table 1: Two-Step Results of GMM System Estimation for the Relationship between Working Capital
Management Measures Including the Cash Conversion Cycle and the Firm's Performance
Dependent Variable: OIS Coefficients

Full period 1990- First period 1990- Second period 1995- Third period 2000-
Exploratory Variables:
2004 1994 1999 1994
LOIS 0.1093742** 0.3891377 0.1754836** 0.0521925**
QR -0.0209257* 0.0071134 -0.0309328* 0.0572961*
TDE 6.04e-08 -2.97e-07 -4.49e-07 5.30e-07
SG 0.0027879 0.004226 0.0293055 0.0018839
RCP -0.0169117** 0.0002769 -0.001792 -0.0169529**
ICP -0.0015936** 0.0011912 0.0023982** -0.0020329
PDP -0.0057129** -0.0014022 -0.0038863** -0.0069267**
CCC -0.0024813** -0.0006869 -0.0014406** -0.002616**
Constant -0.0196783** 0.0017403 0.0016587 -0.0401378*
Sargan 101.76 4.17 24.47 63.14
Order 1 -1.16 -1.67 -1.53 -1.14
Order2 0.79 -1.03 0.16 0.87
Note: * significant at 95% confidence level, * *significant at 99% confidence level
Table 1 reports the results of Arellano-Bond dynamic panel-data two- steps GMM system estimation for the relationship
between the components of working capital management and the firm's performance for an unbalanced sample of
5802 U.S. non-financial firms listed in the New York Stock Exchange, American Stock Exchange, NASDAQ
Stock Market and the Over The Counter Market for the period 1990-2004 and the three sub-periods. The
dependent variable and all the independent variables are in the form of first difference. (OIS) is the dependent
variable of operating income to sales, the exploratory variables are: (LOIS) is the lagged operating income to sales,
(QR) is the quick ratio, (TDE) is the total debt to equity ratio, (SG) is the sales growth, (RCP) is the receivables
collection period, (ICP) is the inventory conversion period, (PDP) is the payable deferral period, and (CCC) is the
cash conversion cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the Arellano-
Bond test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that
average autocovariance in residuals of order 2 is 0.
Table 2: Two-Steps Results of GMM System Estimation for the Relationship between Working Capital
Management Measures Including the Net Trade Cycle and the Firm's Performance

Full period 1990- First period 1990- Second period Third period 2000-
2004 1994 1995-1999 1994
LOIS -0.8633548** -1.877821** .0608843** -0.0459073
QR -0.2516475** -0.0145362** -.1053771** -0.0037797
TDE -1.37e-08 7.52e-09 -6.87e-06 3.12e-06
SG -0.2422801** -0.5252024** .0156748** -0.0167827
RCP 0.0082238** 0.002182** .0039755** 0.0058274
ICP -0.0302019** -0.0020263** -.01653** -0.0174298
PDP -0.0045405** -0.0112586** -.0036845** -0.0038884
NTC 0.0012844** -0.0003207** -.0021981** -0.001714
Constant -0.025087** -0.0502549** -.0201984** -0.0079269
Sargan 95.34 118.19* 108.15 124.41*
Order 1 -1.00 -1.26 -1.12 -1.49
Order2 -0.48 -0.97 -1.01 -1.50
variable of operating income to sales. The exploratory variables are: (LOIS) is the lagged operating income to
sales, (QR) is the quick ratio, (TDE) is the total debt to equity ratio, (SG) is the sales growth, (RCP) is the
receivables collection period, (ICP) is the inventory conversion period, (PDP) is the payable deferral period, and
(NTC) is the net trade cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the
Arellano-Bond test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test
that average autocovariance in residuals of order 2 is 0.
Table 3: Tow-Steps Results of GMM System Estimation for the Relationship between Working Capital
Management Measures Including the Operating Cycle and Firm's Performance

Full period 1990- First period Second period Third period 2000-
2004 1990-1994 1995-1999 1994
LOIS 0.3568988** -0.2534245** 0.643047** 0.2360323**
QR 0.0592325** 0.1027286** -0.0325934** -0.0181161**
TDE -7.14e-07 6.18e-06** -5.46e-06* 4.56e-08
SG 0.1050283** -0.0413975** 0.0875618** 0.1721182**
RCP -0.0020604** -0.0038678** -0.0041003** 0.0020457**
ICP 0.0015482** 0.005273** 0.0020449** -0.0031134**
OC -0.0013115** -0.0017843** -0.0019953** -0.0001568
Constant 0.0033737* -0.0049928** 0.0031675* -0.0023532*
Sargan 110.81 99.26 90.10 124.34*
Order 1 -2.02* -0.91 -2.09* -0.99
Order2 -1.01 0.85 0.61 -1.16
variable of operating income to sales, the exploratory variables are: (LOIS) is the lagged operating income to sales,
(QR) is the quick ratio, (TDE) is the total debt to equity ratio, (SG) is the sales growth, (RCP) is the receivable
collection period, (ICP) is the inventory conversion period, (PDP) is the payable deferral period, and (OC) is the
operating cycle. Sargan is the Sargan test of over-identifying restrictions, P> Chi2. Order 1 is the Arellano-Bond
test that average autocovariance in residuals of order 1 is 0, and Order2 is the Arellano-Bond test that average
autocovariance in residuals of order 2 is 0.
The results of the empirical analysis of this paper suggest that shortening the cash conversion
cycle decreases rather than increases firm’s profitability. This signifies the importance of identifying an
optimal length of the cash conversion cycle where the total holding and opportunity costs of current
assets are minimized and the profitability of firms is maximized. The results of the net trade cycle and
the operating cycle can be interpreted similarly for the results of the cash conversion cycle.
4. Conclusion
One of comprehensive measures of working capital management efficiency is the cash conversion
cycle that considers all financial flows associated with inventory, receivables and payables. The
traditional link between the cash conversion cycle and the firm's profitability is that reducing the cash
conversion cycle by reducing the time that cash is tied up in working capital improves the firm’s
profitability. This could happen by shortening the inventory conversion period via processing and
selling goods to customers more quickly, by shortening the receivables collection period by speeding
up collections, or by lengthening the payable deferral period via slowing down payments to suppliers.
On the other hand, shortening the cash conversion cycle could harm the firm's profitability; reducing
the inventory conversion period could increase the shortage cost, reducing the receivables collection
period could make the company to lose its good credit customers, and lengthening the payable period
could damage the firm's credit reputation. However, achieving the optimal levels of inventory,
receivables and payables will minimize the carrying cost and opportunity cost of holding inventory,
receivables, and payables and lead to an optimal length of the cash conversion cycle. Hence, we
recommend the optimal cash conversion cycle, the optimal net trade cycle and the optimal operating
cycle as more accurate and comprehensive measures of working capital management that maximizes
sales, profitability and market value of firms.
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An Optimal Cash Conversion Cycle

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An Optimal Cash Conversion Cycle

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International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 120 March, 2014

An Optimal Cash Conversion Cycle

1.1. Optimal Operating Cycle

1.2. Optimal Cash Conversion Cycle

1.3. Optimal Net Trade Cycle

1.4. Optimal Inventory Level

1.5. Optimal Accounts Receivable

Figure 2: Optimal Receivables

1.6. Optimal Accounts Payable

Figure 3: Optimal Payables

2. Data and Methodology

Dependent Variable: OIS Coefficients

Dependent Variable: OIS Coefficients

Dependent Variable: OIS Coefficients

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