The cash conversion cycle, also called the cash cycle, is a working capital metric that shows the number of days or time a company takes to convert its cash into inventory and convert inventory back into cash through its sales process.
The cash conversion cycle helps a company to calculate its operational efficiency and financial performance in the market.
Apart from estimating the operational efficiency of a company, it also helps a company to determine the financial health of the company, track and improve the trade credit with other vendors, and gain easy access to major opportunities for investors and capital loans.
Also known as the net operating cycle, it takes into account the amount of time it will take your company to sell its inventory (days inventory outstanding), the amount of time it takes to collect cash after selling that inventory (days sales outstanding), and finally the amount of time it will take you to pay suppliers and other bills (days payables outstanding).
As with other cash flow calculations, a lower Cash conversion cycle is a good indicator of how efficient your company is because it is a sign that you can quickly purchase inventory, sell it and pay your suppliers.
Why is the cash conversion cycle important?
The cash conversion cycle is an important business metric because it indicates how efficient your company is against your competition in the same industry. Tracking your cash conversion cycle allows your company to see how fast it converts your company's working capital to product or service sales and back to cash again.
The cash conversion cycle is one of the best tools to evaluate your company's performance. Cash conversion cycles that are decreasing or steady are a good sign, whereas rising cash cycles require a little investigation.
The cash conversion cycle measures how fast a company can turn its initial capital money into income. Companies with a low cash conversion cycle are frequently those with the best structural management.
The cash conversion cycle results should be combined with other ratios such as return on equity and return on assets for much more advanced results; compared to industry competitors over and over again per month or week. You should also compare your company's cash cycle changes over the years to get a view of how your company changing in the past years.
Taking actions to boost your company's CCC over time can enhance cash flow, streamline operations, and provide a more stable platform for growth if your company manages inventory, extends credit to customers, and receives credit from suppliers.
Cash conversion cycle formula
The cash conversion cycle has three important stages:
DIO = Days of inventory outstanding (also called days sales of inventory)
This is the average time your company's inventory is converted into products or goods and sold to the market. The way to compute the DIO is by dividing your average inventory by dividing it by your cost of goods sold and multiplying the result by 365.
DSO = Days sales outstanding
The way to compute the DSO is by taking your accounts receivable. Next, divide it by your net credit sales and multiply it by 365. This is the average number of days your company takes to collect your outstanding accounts receivable.
DPO = Days payables outstanding
This is the average time it takes for your company to buy merchandise and then pay them. DPO is calculated by dividing the ending accounts payable by (the cost of goods sold/365).
The DIO and DSO are related to cash inflows, whereas DPO is related to cash outflows. So the DPO should be the only negative number in the cash cycle equation.
Another thing that you need to remember is that the formula of the DIO and DSO is always linked to your company's accounts receivable and product inventory, which are both considered your short-term assets and a positive figure in the equation. On the other hand, the DPO is associated with accounts payable, which is a liability.
Cash conversion cycle calculation
A company's cash cycle is divided into three stages. To be able to calculate your company's cash conversion cycle, you need to prepare these items from the financial statement of your company:
Financial Statements that you will need for the cash conversion cycle:
- Revenue and cost of goods sold (COGS) from the income statement
- Inventory at the beginning and end of the time period
- Accounts receivable (AR) at the beginning and end of the time period
- Accounts payable (AP) at the beginning and end of the time period
- The number of days in the period (e.g., year = 365 days, quarter = 90)
First stage
The first stage of the calculation was to focus on your company's existing inventory levels, and it will estimate how long it will take for your company to sell its remaining items on the inventory. The figure here is derived from the number of days inventory is outstanding (DIO). A lower value of the DIO is preferred because it indicates that your business can sell its products in a short time, implying a higher turnover for your business.
DIO, also known as DSI (days sales of inventory), is calculated using your cost of goods sold (COGS), which is the cost of acquiring or manufacturing a company's products over a given period.
Terms:
Avg. Inventory= 1/2 × (BI+EI)
BI=Beginning inventory
EI=Ending inventory
Second stage
The second stage of cash cycle calculation focuses on your company's current sales and the estimation of how long it will take to collect all the assets generated from your product sales. This stage is computed by dividing the average accounts receivable by revenue per day by the number of days sales outstanding (DSO).
A lower DSO value is highly preferable because it indicates that your company can collect capital quickly, improving its cash position.
Terms:
- Accounts Receivable = 1/2 × (BAR+EAR)
BAR=Beginning AR
EAR=Ending AR
Third stage
And last, the third stage focuses on your company's current outstanding payables. It considers the number of your company's liabilities owed to your company's suppliers for your inventory and other goods purchased, as well as the time span over which the company must pay those liabilities to avoid further law obstructions.
This figure is derived from the days payable outstanding (DPO), which includes accounts payable. It is preferable to have a high DPO value. By increasing this figure, the company can keep its cash for longer, increasing your company's potential to have more investors in the future.
Terms:
Avg. Accounts Payable= 1/2 ×(BAP+EAP)
BAP=Beginning AP
EAP=Ending AP
COGS=Cost of Goods Sold
What's a good cash conversion cycle?
A cash cycle is short. Although you should aim for a shorter cash-to-cash cycle time, APCQ's benchmark research shows that most companies have a positive cash conversion cycle, an average between 30 and 45 days.
If you have a low or a negative cash conversion cycle, then your working capital is not locked up for a long time, and your company has great liquidity.
Many online retailers have a negative cash cycle because they are getting paid immediately when a customer buys a product on their site or online apps, and they don't have to pay for their inventory until customers have paid for them, unlike big companies that are selling their products in a market.
If your business's cash cycle is positive, ensure it is not too high. Because a positive cash cycle indicates how much time your company's working capital is locked up while it waits for the accounts receivable to be paid.
How to shorten your cash conversion cycle
There are several methods for shortening your company's cash conversion cycle.
- For starters, make sure your accounts receivable process is as efficient as possible. Remove unnecessary jargon from your invoices and be clear and precise about the terms you're requesting from the customers. The faster the customer comprehends the invoice, the faster you will be paid.
- You can also reduce your cash conversion cycle by making upfront payments available or providing small discounts on your products to receive early payments. But make sure you have a good procedure and process while having upfront payments or product down payments to avoid any problems.
- You can change your cash flow cycle by investing in real-time analytics, which can provide you with accurate information to help you make better adjustments to improve your company.
- Try to collect all the payments as soon as possible. Also, consider giving minor and small discounts to increase the number of customers that will pay early.
- Also, consider providing better delivery because business experts said that the sooner you get an item out of your inventory into the customer's doorsteps, the faster you will get the payment.
- Always have a lot of payment methods so the buyers can have a chance to choose which way is more convenient. You can also have installment, upfront, and down payment features on your site or in your physical store, making it much easier for your company to receive the payments quickly.
- Also, try to simplify your old invoices; too old could be more efficient for your company. So always make sure to simplify it and that your accounts receivable team is on big focus in determining what information is necessary for your company.
- Automation is also one of the best tools to reduce your cash conversion cycle. Automation tools help to check all file errors from grammatical and structural mistakes.
- There are numerous methods for reducing your cash conversion cycle, but the most important is to use an Automation Tool to correct any grammatical and structural errors in your company's data.
- Also, take advantage of your bank's treasury management services, and check with your treasury management products and services which can help accelerate the collection and posting of your accounts receivable.
- Some customers can buy and pay on the same day, but this is not always possible. Understanding customers and demonstrating empathy will help you get paid faster and possibly retain a potential long-term customer.
Conclusion
The CCC is a working capital metric that shows how long it takes for the cash to be converted; into inventory and then back into cash. A lower Cash Conversion Cycle is a good indicator of your company's efficiency because it indicates that you can quickly purchase products, sells them, and pay suppliers.
The CCC describes how your company converts its working capital to product or service sales and then back to cash. It's a critical business metric because it shows how efficient your company is in comparison to competitors in the same industry.
Investing in real-time analytics is also critical for gathering sufficient information about your company's performance in the market and making necessary adjustments and improvements to the business.
Remember to improve your delivery time and your CC (from inventory to income). Having multiple payment methods available; on your online sites can also help you receive your accounts receivable as soon as possible.
