Foolish Fundamentals: Cash Conversion Cycle

What do stores like Wal-Mart (NYSE: WMT), Home Depot (NYSE: HD), Target (NYSE: TGT), and Lowe's (NYSE: LOW) have in common? Their inventory needs must be massive. How do we go about analyzing their inventories as a measure of performance? By determining the company's cash conversion cycle and inventory turnover.

Although it would take some grade-A imbecility to get there, it's entirely possible under the accrual system in accounting for a company to go bankrupt while showing operating profits. Why? Because you can't pay your vendors with "profits"; you must pay them with cash. A company that does a poor job of bringing in cash, even if it's selling lots of stuff, should be avoided. Let's break this down by components.

1. Days inventories outstanding (DIO)
What we want to know is the number of days it takes for a company to "turn" its inventory. Let's use the fiscal 2005 annual results for Motley Fool Inside Value pick Home Depot.

Home Depot	($ in millions)
Cost of Goods Sold	$48,664
COGS Per Day (annual COGS/365)	$133
Inventories	$10,076
DIO	76

See how that works? Let's do the same thing with the other two components.

2. Days sales outstanding (DSO)
DSO is the amount of time it takes the company, on average, to receive money after it has sold a good or service.

Home Depot	($ in millions)
Revenues	$73,094
Revenues Per Day (annual revs/365)	$200
Receivables	$1,499
DSO	7

3. Days payables outstanding (DPO)
Finally, we have to subtract from this total the number of days the companies hold onto cash after they pay for something. So we must also know the DPO.

Home Depot	($ in millions)
Cost of Goods Sold	$48,664
COGS Per Day (annual COGS/365)	$133
Accounts Payable	$5,766
DPO	43

Now, to finally come up with the cash conversion cycle, you simply add the three numbers for DIO, DSO, and DPO. Be careful, though: DPO is a negative number.

Thus, Home Depot's cash conversion cycle is: 76 + 7 + (-43) = 40 days.

So, even with all of that inventory, Home Depot is still able to convert its own expenditures back into cash in only 40 days. That's astounding. You can also calculate these numbers on a quarterly basis (taking care to divide by 90 instead of 365) to have a more sensitive tool for determining the trend toward faster or slower cash conversion.

Cash conversion cycles don't translate well from industry to industry, so comparing companies that don't directly compete may not be helpful. Still, you can watch these cycles closely on a company-to-company basis, since they might warn of weakening business fundamentals that don't show up elsewhere.

Bill Mann, Shruti Basavaraj, and Adrian Rush contributed to this article.