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IMPACT OF CASH CONVERSION CYCLE ON CAPITAL STRUCTURE

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The cash conversion cycle (CCC) is a critical financial metric that measures the time required for a company to convert its investments in inventory and other resources into cash flows from sales (Sharma et al., 2020). It plays a pivotal role in determining a firm’s liquidity and operational efficiency. Essentially, CCC represents the period between the outlay of cash for raw material and the inflow of cash from the sale of the finished product (Mathuva, 2018). Understanding the CCC is essential in capital structure management, which refers to the way a firm finances its overall operations and growth through a mix of debt, equity, or hybrid securities (Jensen, 2019).

In recent years, managing the cash conversion cycle has gained prominence as it directly affects a company's capital structure. Firms with longer CCC may require more working capital to fund their operations, which could lead to an increased reliance on external financing sources such as debt (Ebben & Johnson, 2021). This reliance on debt could affect the company’s capital structure and increase financial leverage, which in turn affects the company’s risk profile (Garcia-Teruel & Martinez-Solano, 2019). Thus, the cash conversion cycle and capital structure are closely interconnected, and firms must manage both carefully to achieve financial sustainability.

The impact of CCC on capital structure has been examined in various studies, highlighting its significant influence on debt financing decisions. For example, Malik et al. (2022) argued that firms with longer CCCs tend to have higher levels of debt in their capital structures due to their increased need for liquidity. On the other hand, firms that manage to shorten their CCCs tend to rely less on external financing, which can improve their financial flexibility and reduce the cost of capital (Banos-Caballero et al., 2019). This relationship underscores the importance of efficient working capital management as a means to optimize capital structure and ensure financial stability.

The dynamics of the cash conversion cycle are particularly important for small and medium enterprises (SMEs) and businesses operating in highly competitive industries (Lyngstadaas & Berg, 2021). These firms often face significant liquidity constraints and limited access to long-term capital markets. As a result, they are more sensitive to the efficiency of their CCC and its subsequent impact on their capital structure. Efficient management of CCC can help these firms reduce the need for costly external financing and improve their overall financial performance (Lyngstadaas & Berg, 2021).

Moreover, empirical evidence suggests that firms in industries with shorter production cycles and quicker inventory turnover tend to have more flexible capital structures and lower levels of financial risk. In contrast, companies operating in sectors with lengthy production processes and high inventory holding costs, such as manufacturing, tend to rely more on debt financing to support their working capital needs (Baños-Caballero et al., 2019). This indicates that industry characteristics also play a role in determining the relationship between CCC and capital structure.

One of the key considerations in the impact of CCC on capital structure is the role of firm size. Larger firms, which tend to have more diversified revenue streams and better access to financial markets, often exhibit shorter CCCs and greater financial flexibility (Garcia-Teruel & Martinez-Solano, 2019). In contrast, smaller firms, which are more vulnerable to market fluctuations and liquidity shortages, tend to have longer CCCs and rely more heavily on external debt to fund their operations (Sharma et al., 2020). This suggests that firm-specific characteristics, such as size and market power, can influence the way in which

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