The cash conversion cycle (CCC) – also known as the cash cycle – is a working capital metric which expresses how many days it takes a company to convert cash into inventory, and then back into cash via the sales process. The shorter a company’s CCC, the less time a company has cash tied up in its accounts receivable and inventory.
The CCC is an important metric for companies that buy and manage inventory as it is an indication of operational efficiency as well as financial health. That said, it should not be looked at in isolation, but in conjunction with other financial metrics such as return on equity. It is also important to note that CCC is not a significant consideration for all companies, as not every organization will hold physical inventory.
Calculating the cash conversion cycle
The cash conversion cycle encapsulates three key stages of a company’s sales activity:
DIO = Days Inventory Outstanding (average inventory/cost of goods sold x number of days)
DSO = Days Sales Outstanding (accounts receivable x number of days/total credit sales)
DPO = Days Payable Outstanding (accounts payable x number of days/cost of goods sold)
So for example, if a company has DIO of 70 days, DSO of 30 days and DPO of 45 days, its cash conversion cycle will be calculated as follows:
CCC = 70 + 30 – 45
= 55 days
Cash conversion cycle calculator
Analyzing the cash conversion cycle
The typical length of the cash conversion cycle will vary considerably between different industries meaning there is no single figure that represents a ‘good’ or ‘bad’ cash conversion cycle. However, it can be useful to compare the CCC of two companies within the same industry, as a lower CCC may indicate that one company is managing its working capital more effectively than the other. It can also be useful to track the CCC of an individual company over time, as this can demonstrate whether the business is becoming more or less efficient.
Because the CCC includes DIO, DSO and DPO, a high (poor) CCC may also be an indication of specific issues. For example, a company with a high CCC may take a long time to collect payment from its customers, or it may be ineffective at forecasting demand for its products, meaning that it takes a long time to convert inventory into sales. A high or increasing CCC may also suggest that a company is not using its short-terms assets as efficiently as it could.
Negative cash conversion cycle
While the cash conversion cycle is usually a positive figure, some companies may have a negative cash conversion cycle. In this situation, the company is effectively receiving payments for the goods it sells before paying its suppliers for materials. This can be achieved through a combination of selling inventory rapidly, collecting payment from customers promptly, and paying the company’s suppliers at a later date. Typically, a negative cash conversion cycle is associated with highly efficient online retailers.
How to improve the cash conversion cycle
In order to improve (reduce) the CCC, companies can focus on any of its three components. Increasing DPO, reducing DSO or reducing DIO will all reduce the CCC. Companies can therefore improve the cash conversion cycle in one of several ways:
Convert inventory into sales faster
Collect payment from customers sooner
Extend the time taken to pay suppliers
However, it is important to understand that a company’s cash conversion cycle does not exist in isolation, as it describes the way a company interacts with its suppliers and customers. So, if a company extends the time it takes to pay its suppliers, those suppliers will see an adverse impact to their own cash conversion cycle via an increase in their DSO. In some cases, suppliers may face cash flow pressures that could potentially hinder their ability to fulfil orders on time.
Consequently, purchasing companies may choose to strengthen their supply chains by taking advantage of early payment programs such as supply chain finance. Suppliers can thereby receive early payment on their invoices from a third-party funder, while the company pays the invoice at a later date. This type of solution can enable both buyer and supplier to optimize their working capital positions.