A Cash Conversion Cycle Approach to Liquidity Analysis

Abstract

Although working capital management receives less attention in the literature than longer-term investment and financing decisions, it occupies the major portion of a financial manager's time and attention [9, p. 173]. In part, this simply reflects the repetitive nature of investment commitments with relatively short life expectancy and rapid transformation from one investment form to another [6, pp. 1-2]. The time devoted to working capital management, however, also reflects the crucial liquidity or repayment capability implications of a firm's short-term investment and financing policies. Inattention to the liquidity management process may cause severe difficulties and losses due to adverse short-run developments even for the firm with favorable long-run prospects. Incorrect evaluation of the liquidity implications of a firm's working capital needs may, in turn, subject creditors and investors to an unanticipated risk of default. Financial managers and their external financial analyst counterparts recognize, at least intuitively, that all working capital investments do not enjoy the same life expectancy, nor are they transformed into usable liquidity flows at the same speed. It is not clear, however, that they recognize explicitly the crucial role f these differences in evaluating a firm's liquidity position. A cash conversion cycle approach to working capital management illustrates the potential danger of an intuitive approach to liquidity analysis.

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