Foolish Fundamentals: Cash Conversion Cycle -- Retail

The retail industry is an interesting area of the market. It's a relatively simple business to understand and lends itself to the Peter Lynch mantra of "buy what you know." To find an investment idea, all a Fool has to do is take a trip down the street to the closest mall.

If only it were that easy. How can we tell if one retailer is better than another? Recently, The Motley Fool has detailed that it's important to track same-store sales growth, as well as inventory trends at a retailer. But in terms of comparing trends between firms, the cash conversion cycle is a great way to distinguish which retailers are performing well and which ones have some work to do.

Cash conversion cycle
Retailers create cash by buying goods from suppliers and selling them to consumers. Typically, they skim little pieces of cash off of lots of transactions. In one fell swoop, the cash conversion cycle, or CCC, can illustrate just how efficiently a retailer buys goods to put in inventory, sells them and collects payments from its customers, and pays its suppliers.

Here's how:

CCC = Days in Inventory + Days in Receivables - Days Payable Outstanding

As an example, let's look at Wal-Mart's (NYSE:WMT) cash conversion cycle.

Wal-Mart is perhaps the paradigm case for a retailer; its size and operational/logistics savvy provide it the clout to manage the three key components of the CCC. In the end, it takes just over 13 days for Wal-Mart to purchase inventory and convert it into cash. That's amazing for a company its size!

The finer points
Granted, it takes some time to calculate each component, but this is a very informative exercise and only requires a company's income statement and balance sheet. Let's take each of the three main components and break them down.

Days in Inventory
Typically, the faster merchandise is moving off the shelves and out of the store via a customer's shopping bag, the better. To measure how fast inventory is moving, or turning over, we calculate the Days in Inventory (DII). The lower the DII, the less time inventory is sitting on the shelves. The calculation is as follows:

DII = 365 days/(costs of goods sold/average inventory)

365 represents the number of days in a year; you can also use 90 days if you want to measure quarterly performance. DII represents the number of days the inventory sat around during the period. Again, a lower number is better, as it implies inventory is being sold quickly.

Days in Receivables
Day in Receivables (DIR) is how long it takes for a company to get paid when its customers buy using credit. The calculation is as follows:

DIR = 365 days/(sales/average accounts receivable)

For DIR , the lower the better, as it implies a store's customers are paying off their bills quickly -- always a good thing.

Days Payables Outstanding
Days Payables Outstanding (DPO) is how long it takes for a company to pay its suppliers. The slower a company pays its bills (within reason, of course), the better, as hanging on to cash awhile longer can mean higher interest earned and more flexibility as liquidity is higher. The calculation is as follows:

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

DPO is the opposite of the first two: the higher the number, the better. That's because a retailer wants as much time as it can take to pay off its bills.

Putting it all together
To put it all together, we take the amount of time a company takes to receive payment from customers after purchasing inventory (DII plus DIR), less the number of days a company takes to pay its supplies (DPO). To give you an idea of what these numbers tell us, I've calculated the CCCs for some fashion retailers.

Source: Most recent annual data from company 10-K filings.

So what to make of all the numbers? The most important first step is to see if any of them jump out and warrant further explanation. For instance, Coach's numbers stick out like a sore thumb: why is its CCC so much higher than the rest of the companies listed? Probably because Coach sells much more expensive purses and leather goods that take longer to sell than apparel and related accessories. Therefore, it's reasonable to expect DII to be higher, and customers may take longer to pay for $300 items, which increases DIR. Coach may also have higher profit margins, a metric not reflected in CCC, illustrating that there are always a multitude of interrelated factors to consider when analyzing a company.

Abercrombie also has a higher DIR number than the other retailers listed. The reason? It reports its expenses differently than other retailers. If additional expenses are added to cost of goods sold to create a better comparison, its DIR number falls. This is a valuable reminder that we must make sure we understand how a company accounts for its numbers during our analyses.

As a final highlight, fellow Fool Dave Meier pointed out that in its 10-K filing, Aeropostale considers any credit card with a maturity of less than three months to be a cash equivalent, explaining the goose egg under DIR and at least partially accounting for why its CCC comes close to matching mighty Wal-Mart. Again, watch the way companies account for their numbers!

The Foolish bottom line
CCC is even more useful when looking at multiple time frames (such as quarterly or over the past few years) to view trends or when comparing a company to its closest competitors to see if any stand out in either a positive or negative light. It's also important to note that retailing is seasonal, so quarterly trends can fluctuate considerably, such as when inventory is ramped up for the back-to-school season or the all-important holiday time of year. Finally, once the numbers are run, it's advisable to see if there are any potential red flags and to do some more due diligence, as CCC is only one of the key ingredients for finding a compelling retail investment (click here for an example about a bad trend in DPO).

Hopefully you're now convinced that delving into the details of a company's CCC can be an indispensable way to differentiate among retailers that at first glance appear identical. I mean, jeans are jeans, right?

Here are some other Foolish Fundamental articles to help you become a better investor:

• Foolish Fundamentals: Same-Store Sales
• Foolish Fundamentals: Inventory
• Foolish Fundamentals: Margins

Wal-Mart generates an amazing amount of cash. No wonder it's an Inside Value pick. Click here to see what other cash-generating machines lead analyst Philip Durell is finding at bargain prices.

American Eagle is a Stock Advisor recommendation.

Fool contributor Ryan Fuhrmann contributed to this article. He has no financial interest in any company mentioned. Feel free to e-mail him with feedback or to further discuss any companies mentioned. The Fool has an ironclad disclosure policy.