The cash conversion cycle (CCC) – also known as the cash cycle – is a metric expressing how many days it takes a company to convert the cash it spends on inventory back into cash by selling its product. The shorter a company’s CCC, the less time it has money tied up in accounts receivable and inventory.
The cash cycle is an important working capital metric for all companies that buy and manage inventory. It’s an indicator of operational efficiency, liquidity risk, and overall 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 the cash cycle is not a significant consideration for companies that don’t 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 and avoid common cash flow problems 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.
Research indicates that the median cash conversion cycle is between 30 days and around 45 days. Aiming to reduce your cash cycle to 45 days or less would mean you turn cash into inventory and back again quicker than the average business. However, what really constitutes a ‘good’ CCC depends on a range of factors, including the sector you’re operating in.
Companies can reduce their cash conversion cycle by turning over inventory faster. The quicker product is sold, the sooner cash can be received for the sale. Managing inventory more effectively by prioritizing quick turnover is conducive to a low cash conversion cycle.
Reducing the length of the cash conversion cycle is also possible by improving performance in any one of the three metrics used to calculate it: days payable outstanding (DPO), days sales outstanding (DSO), and days inventory outstanding (DIO). Increasing DPO, decreasing DSO, or decreasing DIO will result in a shorter cash conversion cycle.
To increase DPO, you can try to negotiate longer payment terms with your suppliers so you can keep hold of your cash for longer. To decrease DSO, think about changes you can make to speed up your collections process, such as automating the invoicing process. To decrease DIO, reconsider your inventory management strategy and make changes to minimize stock on hand.
Most companies will have a positive cash conversion cycle, representing that it takes X number of days for them to turn cash into inventory and back again. However, a negative CCC is also possible when a business receives payments for the goods it sells before it’s paid any of its suppliers. Where that’s the case, the cash conversion cycle will represent how many days before paying its suppliers the business is receiving payment from its customers. This can result in a CCC of -X days.
This is most common with highly efficient e-commerce businesses with high product turnover rates, and especially those that make use of drop shipping. Drop shipping is an inventory management strategy that reduces the burden of carrying inventory on the seller business to zero. Instead of being stored by the retailer, drop shipped products and shipped directly from manufacturer to customer.