Last editedSep 20222 min read
Calculating the cash conversion cycle is an important part of successful cash flow management for any business. This cycle measures the time spent between purchasing inventory or raw materials and receiving payment for goods. Cash conversion cycles can be described as positive or negative – so what is a negative cash conversion cycle, and what does it mean for your business? Here’s a closer look at how it works.
Can cash conversion cycles be negative?
The cash conversion cycle, or CCC, measures the time in days from initial investment to receipt of payment. Normally, this metric is positive because a business purchases inventory before selling it and receiving payment for the item. Yet it’s also possible for the cash conversion to be negative. This occurs when a business sells an item to a customer before paying the original supplier. A negative cash conversion cycle isn’t necessarily a good or bad thing, but it must be accounted for when managing cash flow. Understanding the order to cash cycle helps measure how long your business has to pay its bills, with cash flowing in and out over time. Generally, lower CCC numbers are better for business because they indicate swifter returns on investment and better money management.
Examples of negative cash conversion cycle
Now that we’ve described how the CCC works, what are a few examples of a negative cash conversion cycle in action? This type of cycle is seen frequently with online marketplaces like eBay and Amazon. Third-party sellers use these online platforms to sell goods and receive payment, but the platform might not pay the seller until after the sale has concluded. The platform retains cash from the buyers for a certain number of days, during which time it has a negative cash conversion cycle.
For an independent example, imagine that you run a vintage clothing boutique. You purchase some antique jewellery and sell it at a weekend vintage fair, but don’t pay the original supplier until after you’ve made your sale.
How to calculate cash conversion cycle
The cash conversion cycle formula is straightforward:
Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding
In other words, you must subtract the number of days it takes to pay cash for your inventory or supplies from the total time needed to get paid in cash for the finished product. This is an important distinction to make – the CCC uses cash as its basis rather than income. Income is earned as soon as a product is sold, no matter how long it takes to receive the payment in your account. Cash is only recognized when it is exchanged. This is what makes it possible for the cash conversion cycle to be negative. There can be a lag between paying your supplier or vendor and collecting payment for selling the goods. If you sell the goods before paying your supplier, you will have a negative CCC.
What does a negative cash conversion cycle mean for your business?
The longer it takes to convert investments into cash, the more financially stretched a business will feel. A smaller cash conversion cycle indicates that your business has more cash on hand, making it easier to pay outstanding bills. But what does a negative cash conversion cycle mean for business? This is an advantageous position to be in if you remember to pay your suppliers quickly after selling goods or services. Holding onto cash from sales for too long can damage your supplier relationships and brand reputation.
GoCardless partners with accounting software like Xero and Salesforce to help you better manage your cash flow over time. Using pull-based direct debits, you can take payment directly from customer bank accounts on the day they’re due and improve cash flow via the cash conversion cycle.
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