The Cash Conversion Cycle (CCC) is a statistic that assesses a company’s cash flow management efficiency. The cash conversion cycle is also known as the net, operating, or asset conversion cycle. It calculates how long a company turns its inventory and other resources into cash. By calculating the cash conversion cycle, a business can determine how long it takes to generate cash from its operations and identify areas where it can improve its cash flow.
The cash conversion cycle is a valuable metric for companies that rely on inventory and accounts receivable to generate revenue. The cash conversion cycle calculation involves three key components:
- the average time it takes to sell inventory.
- the average time it takes to collect accounts receivable.
- the average time it takes to pay accounts payable.
The cash conversion cycle may be calculated using the following formula:
Where,
DIO = Days Inventory Outstanding
DSO = Days Sales Outstanding
DPO = Days Payable Outstanding
To evaluate the cash conversion cycle, you must first determine the length of time it takes to sell inventory. This is calculated by dividing the total inventory by the cost of goods sold (COGS) per day. Once you have this figure, you can evaluate the average time it takes to collect accounts receivable by dividing the total accounts receivable by the sales per day. Finally, you can calculate the average time to pay accounts payable by dividing the total payable by the COGS per day. The cash conversion cycle is computed by adding the average time it takes to sell inventory to the average time it takes to collect accounts receivable and then subtracting the average time it takes to pay accounts payable.
Days Inventory Outstanding (DIO) is a metric that indicates how long it takes a firm to turn its inventory into sales. A high DIO suggests that a company holds too much inventory, which ties up valuable cash resources that could be used elsewhere.
Days Sales Outstanding (DSO) is a metric that evaluates how long a firm takes to collect payment from its customers on average. A high DSO indicates that a company needs to collect payments from its customers on time, which can create cash flow problems and pressure the company to meet its obligations.
Days Payable Outstanding (DPO) is a metric that quantifies how long it takes a corporation to pay its suppliers on average. A high DPO indicates that a company must take more time to pay its suppliers, which can damage its relationship with its suppliers and lead to cash flow problems.
By subtracting DPO from the sum of DIO and DSO, we measure how long a company can convert its inventory into cash.
A positive cash conversion cycle means that a company is generating cash from its operations, while a negative cash conversion cycle means that a company is using cash to finance its operations.
Let’s look at an example to understand the cash conversion cycle calculation.
Example:
ABC Company has Rs.50,000/- worth of inventory, Rs.25,000/- in accounts receivable, and Rs.10,000/- in accounts payable. The company’s COGS is Rs.1,50,000/-, and its sales are Rs.2,50,000/-.
days
days
days
days
This means that it takes ABC Company an average of 135 days to convert its inventory and accounts receivable into cash, after taking into account the time it takes to pay its accounts payable.
Why is the Cash Conversion Cycle Important?
The cash conversion cycle is an essential indicator for businesses since it provides vital information about their cash flow management efficiency. A shorter cash conversion cycle means that a company can generate cash more quickly from its operations, which can improve its liquidity and financial health.
A company with a long cash conversion cycle may need help meeting its financial obligations, such as paying suppliers or covering operating expenses. This can lead to cash flow problems, ultimately impacting the company’s ability to grow and compete.
A shorter Cash Conversion Cycle suggests that a firm is properly managing its inventory, receivables, and payables and producing cash from activities. This can free up cash for other uses, such as investing in new projects or paying dividends to shareholders.
A longer CCC indicates that a company takes longer to collect cash from customers and pay suppliers. This can lead to cash flow problems, making it difficult to meet financial obligations or invest in growth opportunities. In some cases, companies may need to take out loans or raise capital to finance operations, leading to higher costs and reduced profitability.
By analyzing the CCC, companies can identify areas where they can improve their cash flow management, such as inventory management or negotiating better payment terms with suppliers. This can reduce the time it takes to convert inventory into cash, which can free up valuable cash resources that can be used to fund growth and generate returns for shareholders.
Furthermore, a company with a long cash conversion cycle may need external financings, such as loans or credit lines, to meet its financial obligations. This can increase debt and interest expenses, further impacting the company’s profitability.
Dr. Utkarsh Amaravat is a banker with vast experience in retail credit. He holds a B.E. Mechanical and MBA Marketing degree from Gujarat Technological University and a Ph.D. in management (Credit Risk Management) from Sardar Patel University. He has mainly experience in sales and processing of credit proposals. Sales/Marketing, Relationship Management, Credit, and Risk Management, including research work are vital domains for him.