Cash Conversion Cycle

Businesses across various industries, financial analysts, and investors use the “Cash Conversion Cycle” as a measure of operational efficiency and liquidity. 

Efficiency and liquidity in a business context refer to how effectively a company manages its resources to generate profits and its ability to quickly convert assets into cash without loss in value. It measures how long it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Other options include: accounts receivable, accounts payable and prepaid expenses. 

Understanding the Cash Conversion Cycle

The Cash Conversion Cycle is a measure of how long it takes for a company to turn its resources, like goods and materials, into money. The shorter the cycle, the more efficient the company is at turning its investments into cash. Investments in the context of a company’s operations can include inventory purchases, production equipment, research and development, marketing campaigns, and technology upgrades. 

The cash conversion cycle is also a measure of a company’s liquidity. A shorter cycle means that the company has more cash on hand, which can be used to meet its short-term obligations. Short-term obligations of a company typically include accounts payable, short-term loans, payroll expenses, taxes due, utility bills, rent or lease payments, and other operational expenses due within a year. 

This can be particularly important for businesses that operate on thin margins or that have high operating costs. Businesses that operate on thin margins or have high operating costs are particularly sensitive to the cash conversion cycle for several reasons: high operating costs, dependency on external financing. 

What are the components of the Cash Conversion Cycle?

The cash conversion cycle is made up of three components: Days Sales Outstanding (DSO), Days Inventory Outstanding (DIO), and Days Payable Outstanding (DPO). 

• Days Sales Outstanding (DSO): days to collect payment after a sale. Lower DSO means Faster collection of outstanding payments.
• Days Inventory Outstanding (DIO): days to turn inventory into sales. Lower DIO means Faster sale of inventory.
• Days Payable Outstanding (DPO): days to pay suppliers. Higher DPO means More time before paying, conserving cash.

What is a good CCC?

CCC differs per industry. For instance, supermarkets may have a shorter cycle than furniture manufacturers, due to their rapid inventory turnover and immediate sales. 

It’s important to analyse the CCC when making strategic decisions related to inventory management, credit policies, or when planning significant capital investments. Because you can make capital investments without straining financial resources. A low Cash Conversion Cycle is preferable because it means a company is more efficient in converting its investments into cash, enabling quicker reinvestment, reduced need for external financing, and enhanced overall financial health.

Reducing the Cash Conversion Cycle is beneficial for enhancing a company’s liquidity and operational efficiency. Several strategies can be employed to achieve this:

1. Improving accounts receivable turnover: by implementing stricter credit policies or offering early payment discounts, companies can encourage customers to pay their invoices faster, reducing the Days Sales Outstanding (DSO). Payt provides an automated accounts receivable platform to help businesses accelerate invoice payments through efficient customer reminder processes, improving cash flow and liquidity.
2. Efficient inventory management: for example, by streamlining inventory processes, employing just-in-time inventory systems. Just-in-Time (JIT) inventory systems streamline production by receiving materials only as needed, reducing storage costs and minimizing excess inventory.
3. Negotiating with suppliers: extending payment terms or negotiating bulk purchase discounts can increase the Days Payable Outstanding (DPO), allowing the company to retain cash longer before settling its payables.

Implementing of these strategies will have a cumulative effect in shortening the CCC, improving a company’s cash position and overall financial health.

Calculating the Cash Conversion Cycle

Calculating the cash conversion cycle involves adding the DSO and DIO and then subtracting the DPO. The formula is as follows:

• CCC = DSO + DIO - DPO

Calculating Days Sales Outstanding (DSO)

Days Sales Outstanding (DSO), which is a measure of the average number of days that it takes a company to collect payment after a sale has been made. Here’s an explanation of the three components of this formula:

Accounts receivable: This refers to the money that is owed to a company by its customers for goods or services that have been delivered or used but not yet paid for. In simpler terms, it’s the amount of money that customers still need to pay to the company.

Credit sales: These are sales where the payment is not received immediately at the time of sale but is instead made on credit. In other words, the company allows the customer to pay at a later date. The total credit sales for a period are used in this formula.

Number of days: This typically refers to the number of days in the period being analyzed. For example, if you’re calculating DSO for a year, you would use 365 days; for a quarter, it would be around 90 days, depending on the specific months included in the quarter.

• DSO = (Accounts Receivable / Credit Sales) x Number of Days

Calculating Days Inventory Outstanding (DIO)

DIO is calculated by dividing the total inventory by the cost of goods sold and then multiplying the result by the number of days in the period.

• DIO = (Inventory / Cost of Goods Sold) x Number of Days

Calculating Days Payable Outstanding (DPO)

The calculation of Days Payable Outstanding (DPO) involves a few steps. First, divide the total accounts payable by the cost of goods sold. Then, multiply this result by the number of days in the period. 

• DPO = (Accounts Payable / Cost of Goods Sold) x Number of Days

Example of Cash Conversion Cycle

Imagine a company in the retail industry. In January, the company reports accounts receivable of $50,000, credit sales of $500,000, an inventory of $200,000, cost of goods sold at $400,000, and accounts payable of $150,000 for a 30-day period. Using the formulas:

DSO = ($50,000 / $500,000) x 30 = 3 days

DIO = ($200,000 / $400,000) x 30 = 15 days

DPO = ($150,000 / $400,000) x 30 = 11.25 days

CCC = 3 + 15 - 11.25 = 6.75 days

This means it takes the company an average of 6.75 days to convert its investments in inventory and other resources into cash from sales. Comparing this to industry standards and historical data can provide insights into the company’s performance.

Interpreting the Cash Conversion Cycle

The cash conversion cycle can provide insights into a company’s operational efficiency and financial health.

It’s also important to consider the trend in the cash conversion cycle over time. If the cycle is getting shorter, it could indicate that the company is becoming more efficient. On the other hand, if the cycle is getting longer, it could signal potential problems with the company’s operations or financial health.