This checklist describes the cash conversion cycle and how it is normally used by businesses.
The cash conversion cycle (CCC) refers to the period of time in which a company is able to convert its resources into cash. Resources can include such factors as labor, raw materials, and utilities. This metric is used as part of working capital analysis. The cycle can, perhaps, be best defined as the time it takes to collect the cash from sales after paying for the resources purchased by the company. The cycle may consist of up to five separate stages of conversion:
Resources into inventories
Inventories into finished goods
Finished goods into sales
Sales into accounts receivable
Receivables into cash
The cash conversion cycle uses a basic formula to calculate the time period, which is always in days, as follows:
CCC = Inventory conversion period (DIO) + Receivables conversion period (DSO) − Payables conversion period (DPO)
Inventory conversion period (DIO) = Inventory ÷ CGS × 365
Receivables conversion period (DSO) = Receivables ÷ Sales × 365
Payables conversion period (DPO) = Accounts payable ÷ CGS × 365
where CGS is cost of goods sold, DIO is days of inventory outstanding, DSO is days of sales outstanding, and DPO is days payable outstanding.
The above formulae should be adjusted to take into account any reduction in requirements due to delaying payment for purchases. The formulae are also based on averages and do not take account of seasonality, or trends in growth, or decline of the business.
The cash conversion cycle is important for both retailers and manufacturers as it measures how quickly a company can convert sales into hard cash. Companies should aim to have the shortest possible cycle as it means capital is tied up for less time, making the bottom line stronger.
Economists cite the CCC as one the most accurate metrics for the real financial health of a company, as it is not only easy to calculate but it also reflects the dynamic situation on a day-to-day basis when you input the data.
In a long cash conversion cycle, capital is locked into core operations and cannot be used for anything else.
Note that often both sales and purchases are made on credit rather than with cash—this difference should be accounted for when calculating the cycle. Special attention should also be given to the length of the receivables processing period: A shorter period is generally best, but in certain circumstances it can sometimes be offset by an increase in that for accounts payable by paying creditors more slowly, although this may be viewed as irresponsible.
Note that the receivables days look backward (debtors arise out of sales that have already been made), whereas the inventory days look forward (inventory is held in order to meet future sales).
The cash conversion cycle can be used as part of a company’s strategy. For example, a firm aiming to be the lowest-price supplier on the market will probably tailor its inventory and receivables days accordingly, with tight payment times and a willingness to accept stock-outs in order to avoid holding excessive inventory. Conversely, a high-end supplier would be more likely to extend generous credit terms, and hold more lines of inventory, to reflect a business model that charges higher prices to its customers.
Dos and Don’ts
Remember that some businesses will have a smaller CCC, such as those selling goods for cash, which therefore have no receivables, or those selling services, which therefore have no inventory.
Remember that the cycle may be negative if a company settles with its creditors immediately after purchasing raw materials, manufacturing the goods, and selling them for cash.
Don’t run any of the formulae without first making the specific adjustments applicable to your business.