It’s important for business owners to have a solid grasp on the cash conversion cycle (CCC), a formula that helps you measure the amount of time it takes to collect cash from sales of your inventory. But how can you make a cash conversion cycle calculation and what does it really mean for your business? Find out more with our definitive guide.
What is the cash conversion cycle?
The cash conversion cycle is a metric that shows you the amount of time (measured in days) that it takes for businesses to convert investments in inventory to cash. Also referred to as the net operating cycle or the cash cycle, the cash conversion cycle formula can help you understand exactly how long each dollar gets tied up in production/sales before it’s converted to cash.
A lower cash conversion cycle indicates that a company has a fast inventory-to-sales pipeline. By contrast, a higher cash conversion cycle may mean that your business is much slower to convert inventory to cash. Although it’s usually preferable to have a lower CCC, the average cash conversion cycle differs significantly across industries.
It’s also worth noting that businesses can have a negative cash conversion cycle. In a nutshell, this means that a company requires less time to sell its inventory and receive cash than it does to pay their inventory suppliers. In other words, if your inventory is sold quickly and you put off payment to suppliers for as long as possible, you’ll have a negative cash conversion cycle.
While CCC is a significant metric for larger retailers that buy and manage inventory before selling them on to customers, it’s not so important for businesses in all industries. For example, software companies that license computer programs can make sales without the need to manage inventory, so cash conversion cycle analysis won’t be particularly useful.
How do you use the cash conversion cycle formula?
There are three distinct parts to the cash conversion cycle formula. To make a cash conversion cycle calculation, you’ll need to know how to calculate the aggregate amount of time that’s involved across the three stages of cash conversion. The cash conversion cycle formula expresses this as follows.
Cash Conversion Cycle = DIO + DSO – DPO
While DIO and DSO refer to cash inflows, DPO covers cash outflow, which is why it’s a negative figure. To complete your cash conversion cycle calculation, you’ll need to work out these three elements of the formula.
What is the days inventory outstanding (DIO) formula?
DIO refers to the number of days that it takes a company, on average, to convert inventory to sales. The formula is as follows:
DIO = Average Inventory / Cost of Goods Sold (COGS) x 365
What is the days sales outstanding (DSO) formula?
DSO indicates the number of days that a business takes to collect on its receivables. The formula is as follows:
DSO = Average Accounts Receivable / Total Credit Sales x 365
What is the days payable outstanding (DPO) formula?
DPO is the number of days that it takes a business to pay back their payables, i.e. invoices from suppliers. The formula is as follows:
DPO = Average Accounts Payable / Cost of Goods Sold x 365
Cash conversion cycle example
So, now that you know how each part of the cash conversion cycle formula works, let’s flesh it out with an example. In our cash conversion cycle example, we’ll imagine that Company A sells agricultural equipment. They have a DIO of 20 days, a DSO of 30 days, and a DPO of 45 days. So, putting it all together, you can work out the cash conversion cycle calculation like so:
CCC = 20 + 30 – 45 = 5
As you can see in the cash conversion cycle example, Company A has a CCC of 5 days, which is relatively low, and indicates that they’re able to convert inventory to cash in an efficient manner.
Understanding the cash conversion cycle calculation
Cash conversion cycle analysis can give you an excellent insight into the efficiency with which your business manages its working capital. If you have a good grasp on inventory management, sales, and payables, it’s likely that you’ll have a strong CCC. You should track your cash conversion cycle over time and compare it with competitors in the same industry to gain a deeper understanding of your firm’s operational efficiency.
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