5 Quick Cash Converters

We've all heard the mantra "cash is king," but cash available today is more kingly than the same money received sometime down the road. We want companies we invest in to be able to quickly turn their products into cash.

We figure out whether a company can do that by calculating its cash conversion cycle. This measures how quickly a company takes its raw materials, creates products for sale, and turns those sales into cash in the bank. The more quickly a company can turn over its inventory, the better job it's doing of efficiently managing its assets.

The cash conversion cycle
There are three components of the cycle: days inventory outstanding, days sales outstanding, and days payable outstanding. Let's look at all three and see how they operate.

Days inventory outstanding (DIO)
Inventory sitting on store shelves or in stockrooms is not doing the company or the investor any good. Management needs to get those Speedos off the racks and onto the beaches of Malibu. How quickly it can do so is measured by the number of days inventory is sitting there, so obviously, the lower the number, the better.

DIO = 365/(cost of goods sold/average inventory)

The 365 represents the number of days in the year, but you could also use 91 to represent a single quarter.

Days sales outstanding (DSO)
When a sale is outstanding, that means the company hasn't yet been paid for it. It's in accounts receivable. We want our companies not only to make a quick sale, but also to get paid for it right away. The faster the better, so once again, a lower number is better.

DSO = 365/(sales/average accounts receivable)

Days payable outstanding (DPO)
While we want customers to pay us quickly, we want to take our sweet time paying our own bills. By paying suppliers slowly, a company has more time to use that cash to earn interest, so we want this number to be higher.

DPO = 365/(cost of goods sold/accounts payable)

We don't need an average of our bills outstanding here; we just need to know the ending number.

Putting it all together
With the three components of the cash conversion cycle calculated, we can figure out how long a company is taking to get paid for the products its customers are buying from inventory (DIO+DSO) minus the number of days it takes it to pay its suppliers (DPO).

Here are five teen-oriented retailers with their corresponding cash conversion cycles:

The first thing that jumps out at you is that Abercrombie's cycle is 75% longer than its next competitor and more than four times longer than Gap's. It's also up 16% from where it was last year. Abercrombie's inventory turns over just three times a year, while Gap and Aeropostale turn theirs over more than 15 times a year.

Why? There's no easy answer discernable from looking at Abercrombie's latest financial reports. While sales were up 18% in the fourth quarter, same-store sales declined by 3% compared to a 28% increase last year. It opened up 11 new Ruehl stores and experienced some lost productivity at its new distribution center, but clothes are simply not moving off the shelves quickly. That doesn't cast much hope for the three new concept stores it plans to unveil in 2008.

Motley Fool CAPS investors don't think too highly of the teen retailer either; they grace it with just two stars. (One star is the lowest rating, five stars the highest.)

Another notable fact is that Gap and Aeropostale don't have any accounts receivable on their balance sheet, while Guess? has a bulging balance. Is it having a tough time collecting, or is it "stuffing the channel" with inventory? A check of its annual report reveals that Guess? acquired a European licensee at the end of the year and assumed its receivables, which accounted for nearly half of that line item's growth. Couple that with the longer payment terms customary in Europe, and we see a plausible reason for the bulge.

That still doesn't change the fact that Guess? takes more than two and a half times as long to convert its inventory into cash than does Gap. Might this suggest that a turnaround could be forthcoming at the troubled Gap? In fact, the CAPS community would rather place their bets with Aeropostale, which has virtually the same turnaround time as Gap but without the problems that go with it.

Got an opinion on whether Abercrombie's sales effort is as naked as its models? Will Aeropostale and American Eagle continue to outperform as Gap falters? Work with tens of thousands of your fellow Foolish investors at Motley Fool CAPS to uncover the best stocks and convert your money into cash profits. Click here to get started right away, at no cost to you.

American Eagle and Gap are both recommendations of Motley Fool Stock Advisor. A 30-day risk-free trial subscription shows you why it's fashionable to beat the market.

Fool contributor Rich Duprey does not own any of the stocks mentioned in the article. You can see his holdings here. Gap is also an Inside Value choice. The Motley Fool has a disclosure policy.