Q: Is the cash impact for the change in inventory days a reliable calculation? It seems there are so many things a business can do impact COGS.
A: It is safe to say that a creative company and a creative accountant can manipulate the sales number, COGS, operating expenses, the A/R balance, the inventory balance, and the payable balance, which makes any equation suspect if the underlying data is suspect.
In the case of the cash impact from a change in inventory days, keep in mind that we remove non-cash charges from COGS before we compute the cash impact. Generally, the most obvious manipulation to COGS comes from the posting of non-cash charges, which can vary greatly by year depending on how they are spread between COGS and operating expenses. The other "manipulation" is the failure to apply the matching principle, which results in an artificially high inventory balance and an artificially low COGS. But that is an issue of accounting competence that becomes less likely as the quality of financial statements improves up the chain from company prepared, to compiled, to reviewed, and to audited.
Q: Please repeat the financing gap.
A: The Financing Gap, also called the Cash Conversion Cycle, is accounts receivable days plus inventory days minus account payable days. There are some variations, such as including accrued liabilities with payables, in computing accounts payable days.
The shorter the cash conversion cycle the better off is the company because it locks up cash for a relatively smaller period of time. Increases in the cash conversion cycle mean that the firm must finance itself for a longer time, which will increase the firm’s short-term financing needs and financing costs.
Financial managers will want to monitor the cash conversion cycle and take action should it begin to lengthen. Shorter cash conversion cycles mean the firm will reduce its short-term financing needs and financing costs.
Course overiew: Advanced UCA Cash Flow: Part II of II