If you have your business running, you must be aware how important cash conversion cycle is. Every business and entrepreneur strive for low cash conversion cycle. That’s because the CCC or cash conversion cycle determines the time taken for a company to convert its investment in inventory to cash flows from sales.
This blog explores how the cash conversion cycle works and how a business can reduce its cash conversion cycle.
Cash conversion cycle (CCC), commonly called the cash cycle or net operating cycle, measures how many days a business takes to convert its investments and inventory into cash through the sales process.
The cash conversion cycle can also be understood as the days the investment money remains tied up in the production and sales stages before it is converted into cash. This indicator determines how long it takes to convert an investor’s capital into cash flows from sales.
This cycle records how long it takes to collect accounts receivable and the time taken for a company’s products to sell.
It measures the duration for which the funds are tied up in the business and how long an investor’s capital is invested in the company before making sales and producing financial gains.
It also specifies the deadline by which a business must pay its debts to avoid penalties.
The cash conversion cycle (CCC) comprises 3 important stages of a company’s sales activity which are as follows:
As such, the Cash conversion cycle (CCC) is computed using 3 other working capital metrics which are as follows:
Days Inventory Outstanding (DIO) is the average number of days a company takes to convert its inventory into sales. It is the number of days, on average, that a company holds its inventory before selling it off. The formula for DIO is given as follows:
DIO = Average Inventory/Cost of goods sold X 365
Days Sales Outstanding (DSO) measures the average number of days a business takes to collect its receivables. Hence, the average number of days it takes a business to collect payment after a sale is given by DSO. DSO is computed using the following formula:
DSO = Average Accounts Receivable/Total Credit Sales X 365
Days Payable Outstanding (DPO) measures how many days, on average, it usually takes a business to settle its debts. Therefore, DPO measures the days, on average, it takes for a business to pay its trade creditors, or suppliers, for their invoices. DPO is computed using the following formula:
DPO = Average Accounts Payable/Cost of goods sold X 365
Among these, DPO is considered to be a liability while DIO and DSO are classified under short-term assets.
Now, bringing it all together we can finally obtain the Cash conversion cycle formula:
CCC = DIO + DSO – DPO
Given below is a cash conversion cycle example:
Assume the following details for the year 2018-19 for a company ABC:
Here is how you can now calculate the cash conversion cycle of the business:
Step 1: Calculate DIO
DIO = Average Inventory/Cost of goods sold X 365
= 10,000/40,000 X 365
Step 2: Calculate DSO
DSO = Average Accounts Receivable/Total Credit Sales * 365
= 12,000/80,000 * 365
Step 3: Calculate DPO
DPO = Average Accounts Payable/Cost of goods sold * 365
= 14,000/40,000 * 365
Step 4: Calculate the final CCC
Therefore, the Cash conversion cycle = DIO + DSO – DPO
= 91.25 + 54.75 – 127.75
= 18.25 days
Hence, the business’ cash conversion cycle is of approximately 18-19 days. This means that it takes 18-19 days for this company to go through the cash conversion cycle and generate cash from its inventory.
Usually an organisation’s business management team uses the CCC to measure the effectiveness with which a business manages its working capital and cash flow. The shorter the cash conversion cycle, the faster the company is at selling the inventories and recovering cash from the sales while also paying the suppliers.
One way to determine whether a company’s working capital management is deteriorating or improving is to compare its current conversion cycle to CCC from prior years. It can also be determined how efficient a company’s cash conversion cycle is vis-a-vis its peers by comparing the CCC of the company to those of its competitors in the same sector.
Investors in a company can also use CCC as a metric to understand the efficiency of the company’s management. A low or decreasing CCC indicates effective management in the company which boosts investor sentiment.
Here are some benefits of using the cash conversion cycle as a metric in analysing a business;
The company’s management can get a sense of the company’s financial health using the CCC along with other metrics. The quicker the business can convert cash, the better the cash flow.
An increase in the company’s cash flow indicates that the business is making faster sales. It reduces the risk of liquidation that may result due to a lack of cash flow to pay creditors, suppliers, and employees.
While there are multiple benefits to the cash conversion cycle, it some drawbacks that you must be aware of:
It is not the most accurate indicator of a company’s efficiency. It only discusses the time between inventory acquisition and return generation.
While it is a useful indicator to assess the business’ liquidity and cash flow, it does not take other important parameters into account. The management typically views a faster cash conversion cycle compared to its competition as a positive sign. However, it might lead to unwanted complacency in how the company operates moving forward.
The industry standards for the cash conversion cycle can change based on market conditions and adjustments to the business environment.
One of the easiest ways to bring the CCC down is by increasing the Days Payable Outstanding (DPO), reducing the Days Inventory Outstanding (DIO) or reducing the Days Sales Outstanding (DSO). Here’s how this can work:
For businesses that acquire and manage inventory, CCC is extremely crucial because it reflects both the operational and financial health of the organisation. However, not all businesses will give CCC much thought, as physical inventory isn’t mandatory in various types of enterprises.
Additionally, it must be remembered that the cash conversion cycle must be considered alongside other financial indicators like return on equity rather than evaluating it standalone in order to get a more holistic view of the financial and operational performance of the business.
Ans. Cash conversion cycle meaning is the time a company requires (in days) in order to sell its inventories and resources to generate cash.
Ans. For cash conversion cycle calculation, the following formula is used:
Days inventory outstanding (DIO) + Days sales outstanding (DSO) – Days payables outstanding (DPO)
Ans. Cash conversion cycles are dependent upon the type of industry, management, and various other factors. However, the general notion is that the faster the resources convert into cash, the better it is for the business entity.
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
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