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ARMONK, N.Y. (
makes the world go around. That became terrifyingly clear when the
ground to a halt last fall.
With the market sinking and fear mounting, the government raised insurance limits on savings accounts and insured money market accounts for the first time. These moves were meant to keep people from sucking their funds out of the financial system and stuffing them into their mattresses, hurting the flow of cash to businesses.
Given this crucial need, it makes sense to invest in companies with ample funds. To find these stocks, you could look for strong free cash flow and high quick ratios. But the cash conversion tool goes a step further in gauging the efficiency of a business, how fast it can turn cash into profit.
The cash conversion cycle measures how long it takes a company to recoup its production costs. It looks at the cost of making and selling a product, and the time it takes for customers to pay for it. Obviously, the faster the money is returned the better.
To evaluate a company's cycle, you need its income statement and balance sheet. Use those documents to fill in this formula:
(Average accounts receivable / revenue) X 365
+ (Average inventory / costs of goods sold) X 365
- (Average accounts payable / cost of goods sold) X 365
= Cash conversion cycle
To find averages for these categories, add the most recent year-end data to the previous year's data and divide it by two. This adjusts for the fact that balance sheets reflect a specific time period rather than a trend.
The final number reflects the number of days cash is tied up in the sales process. Apply this to the biggest companies in the world, and you'll draw some interesting conclusions.
Johnson & Johnson
, for instance, has reduced its cash conversion cycle from 85 days in 2006 to 73.6 days in 2008. This shows that Johnson & Johnson is turning over cash faster, whether it's by forecasting its inventory better, pressuring customers to pay their bills or extending payments to suppliers.
has been less successful in managing its cash cycle. Its cycle has gone from an extremely long 146.8 days in 2006 to 183.4 days in 2008. That means that every dollar Merck spends on its products will be locked up for six months, drastically reducing its access to vital capital. Nimble, Merck certainly isn't.
It could be worse. In 2006 it took
nearly a year to recoup its expenses. The cycle dipped to 241.7 days in 2007, but jumped to 273.7 days in 2008.
While the absolute figure is important, the trend is much more compelling. If Pfizer had shortened its cycle in 2008, the stock would have been more appealing because it would have showed that management was fixing the company's problems. Pfizer's relapse into a nine-month cycle should be worrisome to investors.
is a model citizen by this measure. In 2006, the company had a conversion cycle of nearly 75 days. This figure fell to 52 days in 2007 and 45.7 days in 2008. This slow and deliberate improvement is straight out of a textbook on proper cash management.
When making investment decisions, look for companies with short or improving cash conversion cycles. These firms not only have better access to funds, but their management teams are actively addressing problems before they hit the bottom line.
-- Reported by David MacDougall in Boston
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.