Cash Conversion Cycle

Cash Conversion Cycle

What Is the Cash Conversion Cycle?

The cash conversion cycle (CCC) is a metric that expresses the time between a company’s purchase of inventory and the collection of receivables from customers minus any payments due.

In other words, it measures how long it takes for a company to turn its investments in inventory and other short-term assets into cash from sales.

A company’s CCC can be calculated by adding together the days sales outstanding (DSO), days of inventory outstanding (DIO), and subtracting out days payable outstanding (DPO).

 

Why Is the Cash Conversion Cycle Important?

Because the CCC measures how long it takes a company to turn its investments in inventory and other short-term assets into cash, it is an important metric for management to track.

A high CCC can indicate that a company is tieing up too much capital in inventory and other short-term assets, which can lead to cash flow problems.

Additionally, a high CCC can be a sign that a company’s credit terms are too generous or that its payment collections process is inefficient.

 

How Is the Cash Conversion Cycle Calculated?

The cash conversion cycle is calculated via the following formula:

 

CCC = DIO+DSO−DPO

 

Where:

  • DIO = Days of inventory outstanding (also known as days sales of inventory)
  • DSO = Days sales outstanding
  • DPO = Days payables outstanding

To calculate the cash conversion cycle, you’ll need to get information from the company’s financial statements:

  • Annual revenue
  • Average inventory over the period
  • Cost of goods sold (COGS, sometimes called cost of sales)
  • Accounts receivable
  • Accounts payable

You then use this information to find:

  • Days of Inventory Outstanding (DIO)
  • Days of Sales Outstanding (DSO)
  • Days of Payables Outstanding (DPO)

Days of Inventory Outstanding (DIO)

DIO pertains to how many days it takes to sell inventory. The smaller the DIO, the better, because it means a company can convert its inventory to cash faster.

To calculate DIO, we need to start with average inventory:

 

(Beginning Inventory + Ending Inventory) / 2

 

It can then be used to calculate DIO:

 

Average Inventory / COGS

Days of Sales Outstanding (DSO)

DSO stands for days sales outstanding, which is the number of days a company takes to collect on sales. This is found via accounts receivable (often abbreviated A/R or AR).

First, calculate the average accounts receivable:

Average accounts receivable / 2

Then, use that to find the DSO:

 

(Accounts Receivable / Annual Revenue) x Number of Days in Period

Days of Payables Outstanding (DPO)

DPO is days payable outstanding.

This deals with a company’s accounts payable (AP), or the bills it has to pay.

If DPO can be maximized, the company can hold onto its cash longer and maximize the investment potential of that cash.

Therefore, the longer the DPO, the better.

Ending Accounts Payable / (COGS / Number of Days)

Cash Conversion Cycle

Then use the output of each of the three to calculate the Cash Conversion Cycle:

Days inventory outstanding + Days sales outstanding – Days payables outstanding

 

Cash Conversion Cycle Explained

 

Example of the Cash Conversion Cycle

Below is an example of how to calculate the cash conversion cycle for a fictional company.


Item FY2022 FY2023
Revenue 10,000 Not necessary
COGS 5,000 Not necessary
Inventory 2,000 4,000
AR 500 300
AP 1,000 600

Average Inventory (2,000 + 4,000) / 2 = 3,000
Average AR (500 + 300) / 2 = 400
Average AP (1,000 + 600) / 2 = 800

Using the formulas mentioned above, the CCC is calculated:

  • DIO = ($3,000 / $5,000) x 365 days = 219 days
  • DSO = ($400 / $10,000) x 365 days = 14.6 days
  • DPO = $800 / ($5,000 / 365 days) = 58.4 days
  • CCC = 219 + 14.6 – 58.4 = 175.2 days

FAQs – Cash Conversion Cycle

What Does Cash Conversion Cycle Mean?

The cash conversion cycle (CCC) is a metric that expresses the time between a company’s purchase of inventory and the collection of receivables from customers.

In other words, it measures how long it takes for a company to turn its investments in inventory and other short-term assets into cash from sales.

Why Is the Cash Conversion Cycle Important?

Because the CCC measures how long it takes for a company to turn its investments in inventory and other types of short-term assets into cash. It is a measure of efficiency.

A high CCC may denote that a company has too much capital tied up in inventory and other short-term assets, which can lead to cash flow problems.

Additionally, a high CCC can be a sign that a company’s credit terms are too generous or that its collections process is inefficient.

What’s a Good Number for the Cash Conversion Cycle?

It depends on the industry, business, and accounting methods.

However, a lower number is generally better than a higher number because it indicates that the company is converting its assets to cash more quickly.

 

Summary – Cash Conversion Cycle

The cash conversion cycle (CCC) is a metric that expresses the time between a company’s purchase of inventory and the collection of receivables from customers.

In other words, it measures how long it takes for a company to turn its investments in inventory and other short-term assets into cash from sales.

A company’s CCC can be calculated by adding together the days sales outstanding (DSO), days of inventory outstanding (DIO), and subtracting out its days payable outstanding (DPO).

The CCC measures the duration of time it takes a company to turn its investments in inventory and other short-term assets into cash, so it’s important for management to track this metric in retail businesses especially as matter of determining efficiency.

A high CCC can indicate that a company is tying up too much capital in inventory and other short-term assets, which can lead to cash shortfalls, if management isn’t careful.

Moreover, a high CCC can be a sign that a company needs to tighten its credit terms or tighten its collection process to get the cash it is owed faster.

Generally, a lower number is better than a higher number for the cash conversion cycle because it indicates that the company is converting its assets to cash more quickly. However, the ideal number will depend on the industry and type of business, as well as the type of accounting methods they follow.

 

 

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