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The cash conversion cycle (CCC) measures the efficiency of a company's cash flow management. It represents the time it takes for a company to convert its investments in inventory and other resources into cash inflows from sales. In other words, it measures how quickly a company can convert its investments into cash and then use that cash to invest in new opportunities.

The CCC is calculated by adding the number of days it takes for a company to sell its inventory (days of inventory on hand, DOH), the number of days it takes for the company to collect payment from its customers (days sales outstanding, DSO), and subtracting the number of days it takes for the company to pay its suppliers (days payable outstanding, DPO):

\[\text{cash conversion cycle} = \text{days of inventory on hand (DOH)} + \text{days sales outstanding (DSO)} - \text{days payables outstanding (DPO)}\]

A lower CCC is generally better as it indicates that a company can generate cash quickly and efficiently, meaning that less of the company's capital is devoted to working capital（營運資金）. A high CCC may indicate that a company is taking longer to convert its investments into cash, which could lead to cash flow problems and potentially limit the company's ability to invest in growth opportunities.

A company can decrease its CCC by decreasing its inventories and receivables or by increasing (extending) its payables. However, each of these has potential disadvantages:

• Reduced inventories of raw materials may create production bottlenecks due to supply chain disruptions. Reduced inventories of finished goods may mean an inability to meet spikes in customer demand.
• Reducing or tightening credit to customers may result in lost sales.
• We can think of accounts payable as an implicit source of credit from suppliers (as opposed to explicit sources such as bank loans). Suppliers offer payment terms in the form a/b net c, which means a percentage discount of a if the invoice is paid within b days, otherwise full payment is due within c days. Forgoing the discount for prompt payment amounts to borrowing money from the supplier for (c − b) days, at an effective annual rate calculated as follows:

\[\text{EAR of supplier financing} = \left(1 + \frac{a}{1-a}\right)^{\left(\frac{365}{c-b}\right)} - 1\]

where a = percent discount, b = days until discount expires, c = days until full payment is due.

Often, the company could find a lower EAR by borrowing from their lenders as opposed to forgoing the discount.

Cash conversion cycles vary by industry. For example, pharmaceutical companies have long CCCs because they maintain inventories of high-margin drugs to meet unexpected surges in demand. By contrast, airlines have low CCCs because most of their sales are prepaid and they do not keep significant inventories. Analysts should use the CCC to compare companies within the same industry, or to track a company's performance over time.

In addition to the CCC, overall levels of working capital can indicate how efficiently a company manages its liquidity. To compare companies of different sizes, analysts calculate working capital as a proportion of sales. Because the ratio varies by industry, care should be taken to compare firms in similar lines of business. Total working capital is current assets less current liabilities. Analysts often prefer to measure net working capital, using only operating current assets and operating current liabilities, because it is closely linked to the CCC:

\[\text{total working capital} = \text{current assets} - \text{current liabilities}\]

\[\text{net working capital} = \text{current assets (except cash and marketable securities)} - \text{current liabilities (excluding short-term and current debt)}\]

For an asset, liquidity（流動性）refers to its nearness to cash. For a liability, liquidity refers to its nearness to settlement. Assets that can be quickly converted to cash (e.g., marketable securities) are considered highly liquid.

Inventory is less liquid than accounts receivable. Inventory may need processing before a sale, and once sold, inventory might be converted to accounts receivable, which needs to be collected to convert into cash.

For a corporate issuer, liquidity refers to availability of cash and other liquid assets to meet its short-term obligations. Primary liquidity sources include cash and marketable securities on hand, bank borrowings, and cash generated from the business. Long-term solvency of a company depends on its ability to generate sufficient cash from its business to service its liabilities. Analysts evaluate a company's liquidity management primarily by reviewing its statement of cash flows.

Companies generally rely on primary sources of liquidity. However, if needed, the company can rely on secondary liquidity sources, such as the following:

• Cash saved by suspending dividends to shareholders
• Delaying or reducing capital investments
• Selling assets
• Issuing additional equity
• Restructuring debt to extend its maturity
• Bankruptcy protection filing, which suspends the need to service the liabilities

Using secondary liquidity sources sends negative signals to the market, and they are generally more costly than primary liquidity sources.

A company's cash conversion cycle may vary by time of the year (i.e., seasonality) and as business conditions change (e.g., a sudden dip in demand for a company's product will increase inventory and increase DOH). Cash and marketable securities serve as a buffer to meet the company's obligations when there is a deviation from the normal CCC. This excess cash has a cost because it represents capital not invested in the business, but inadequate liquidity can result in having to rely on higher-cost secondary sources.

Factors Affecting Liquidity

An increase in the CCC reduces an issuer's liquidity. The CCC can increase due to drags or pulls on liquidity. A drag on liquidity occurs when cash inflows lag. This can occur when excess inventory builds up or inventory becomes obsolete (DOH increases), or when collections are slow or receivables become uncollectible (DSO increases). A pull on liquidity occurs when cash outflows accelerate. This can occur when suppliers reduce credit lines or demand faster payments (DPO decreases).

Liquidity Ratios

The current ratio（流動比率）is the ratio of current assets to current liabilities. A current ratio greater than 1 indicates that the company has sufficient current assets to meet its current liabilities.

\[\text{current ratio} = \frac{\text{current assets}}{\text{current liabilities}}\]

Not all current assets are equally liquid. Because inventory is the least liquid current asset, the quick ratio（速動比率）excludes inventory from current assets and is a more stringent metric of liquidity.

\[\text{quick ratio} = \frac{(\text{cash and marketable securities} + \text{accounts receivable})}{\text{current liabilities}}\]

Finally, the cash ratio excludes both inventory and accounts receivables and is the most stringent measure of liquidity.

\[\text{cash ratio} = \frac{\text{cash and marketable securities}}{\text{current liabilities}}\]

Working capital management seeks to maximize firm profits while ensuring that sufficient liquidity is available to maintain the firm's operations and meet its obligations. Firms may choose to hold more short-term assets (which offer lower rates of return) to ensure that sufficient cash is available to service its obligations. The firm can also choose to finance its working capital using short-term loans, which are cheaper than sources such as long-term debt and equity. However, the firm must consider the risk of being able to roll over short-term debt at a reasonable cost.

In analyzing different approaches to working capital management, it is important to control for size differences between companies. We do this by calculating companies' relative amounts of long-term versus short-term assets as a proportion of sales.

A conservative approach to working capital management is for the company to hold higher amounts of short-term assets (relative to long-term assets) and finance the working capital using longer-term sources, such as long-term debt and equity. Benefits of a conservative approach include using more permanent capital with less need for rolling over; greater flexibility during market disruptions; and a high probability of meeting short-term obligations. However, the conservative approach results in higher costs and lower profitability. Additionally, long-term lenders may impose operational constraints such as a minimum interest coverage ratio.

An aggressive approach would be to hold relatively lower levels of short-term assets and finance working capital using short-term debt. The benefit of an aggressive approach is lower costs, but its risks are failing to meet business obligations and vulnerability to market disruptions.

A moderate approach seeks to find a middle ground. Permanent current assets are funded using long-term sources of capital, while variable (seasonal) current assets are funded using short-term sources.

Short-Term Liquidity Sources

Firms should maintain a variety of alternative sources and evaluate the costs of each source, while securing sources ahead of time to meet spikes in liquidity needs.

Factors that affect a firm's approach to short-term funding（短期融資）include the following:

• Company size — smaller firms have limited options
• Creditworthiness — which affects the interest rate on loans as well as operational restrictions imposed
• Legal systems — developed economies with well-defined protections for lenders offer more funding alternatives
• Regulatory concerns — firms in regulated industries, such as banks and utilities, have restrictions on funding sources as well as amounts raised
• Underlying assets — that serve as collateral on loans