Cash Conversion Cycle
What is the Cash Conversion Cycle?
The Cash Conversion Cycle, also known as the Cash Cycle, is a measure of the number of days a company takes to convert its inventory into cash flow from sales. In other words, it is essentially the number of days between the payment to the seller (business) for the inventory, and the actual receipt of the money by the seller from the buyer (customer). CCC is an extremely important metric for businesses in certain industries in order to understand how efficient they are in managing their working capital, as failure to do this may result in
- Not being able to meet financial obligations
- Restructuring by selling off assets, and liquidating them in order to meet financial obligations
- Filing for bankruptcy
- Inefficient use of company resources, indicating that its assets are not being utilized optimally to generate a return on investment (ROI)
The CCC takes into account the liquidity risks associated with the manufacturing and sales process, which is the time it takes for the company to sell inventory, obtain credit, and pay bills.
How do we calculate CCC?
There are a few formulas that we need to first understand before being able to calculate CCC.
The formula for calculating CCC is given as
- DIO = Days Inventory Outstanding
- DSO = Days Sales Outstanding
- DPO = Days Payable Outstanding
For example, if your business takes an average of 14.2 days to convert inventory (DIO = 14.2), 15.6 days to receive payment from customers (DSO = 15.6), and 17.3 days to pay suppliers (DPO = 17.3), your money for the conversion cycle will be 12.5 days (or 14.2 + 15.6 - 17.3). However, you might be asking yourself "What is DIO, DSO, or DPO, and how do we calculate them?". In order to answer that, we will break each component into its own heading and delve a little bit deeper into what each term means, how to calculate them, and how to interpret a high versus low metric.
What is Days Inventory Outstanding?
Days Inventory Outstanding, or DIO, is a ratio used in working capital management that measures the average number of days a business holds its inventory before turning it into a sale. This is the number of days it takes a company to process raw materials and/or inventory and receive money from the sale. The formula for DIO is derived from the Inventory Turnover ratio, which measures the rate at which inventory is sold, and then replaced.
The formula for inventory turnover ratio is
The formula for average inventory is given as:
For inventory turnover ratio, the higher the ratio is, the more efficient a company is in selling their inventory quickly, while a low inventory turnover ratio may indicate a weak sales performance. However, an inventory turnover ratio that is too high might indicate that a business does not have enough inventory to match demand, and conversely, an inventory turnover ratio that is too low might indicate an excess in inventory levels with too little demand.
In order to find DIO, we divide 365 by inventory turnover ratio, to determine the number of days a company holds its inventory before it is converted into a sale. Therefore, the formula for this is given as:
The DIO metric tells you how many days it takes for inventory held to be sold. A DIO that is low is positive to investors, as it means it takes a smaller number of days to convert inventory into sales, whereas a higher DIO level indicates that a company is inefficient in converting inventory into sales, and is holding its inventory for too long. You want a low number for this, which means that the items haven't been on the shelves for too long and the customers paid relatively quickly.
What are Days Sales Outstanding?
Days Sales Outstanding (DSO), or accounts receivables days, is another ratio used for working capital management, which measures the average number of days a business takes to convert its' credit sales (or accounts receivables) into cash. The formula for DSO is derived from the Accounts Receivable Turnover ratio, a ratio that measures how effective a company is at extending credits and collecting receivables.
The formula for Accounts Receivable Turnover Ratio is:
The formula for average accounts receivable is given as:
A high accounts receivable turnover ratio may indicate that a company has a strong credit policy, and is efficient and effective at collecting the credit owed. However, an accounts receivable turnover ratio that is too high, might mean that the company is too strict in its credit policy, and may lose customers to competitors. A low accounts receivable turnover ratio may indicate that the company is extending credit to customers that are not creditworthy, do not have strong credit policies, and/or that the company is not good at collecting its debts. For accounts receivable, we generally want a high ratio, but one that is not too high, so customers are not deterred from the extremely strict credit policies, as a high ratio indicates that customers are paying on time and that the company is efficient in collecting receivables and therefore is unlikely to face cash shortages.
In order to find DSO, we divide 365 by the accounts receivable turnover ratio, to determine the number of days it takes for a company to collect payment from a sale. Therefore, the formula for DSO is
A DSO that is low is positive to investors, as it indicates a company takes a shorter number of days to collect payment from customers, contrasting a high DSO value, which suggests a company is taking a long time to collect payment from a sale.
What is Days Payable Outstanding?
Days Payable Outstanding (DPO), or accounts payable days, is a working capital management ratio used to measure the number of days it takes a company to pay back its accounts payable. In other words, it shows how fast the company is at paying off suppliers for inventory and procurement of goods. The formula for DPO is derived from the Accounts Payable Turnover Ratio, a ratio that measures how effective a company is at paying off suppliers.
The formula for Accounts Payable Turnover Ratio is given as:
In order to calculate the total inventory purchased, there is a formula you must employ, as there is no line on the balance sheet, income statement, or cash flow statement that displays total inventory purchased in a particular year.
The formula for total inventory purchased is:
The formula for average accounts payable is
A high accounts payable turnover ratio indicates that a company is paying off suppliers quickly, while lower accounts payable turnover ratio means the company is taking longer to pay off its suppliers. However, a high ratio is not always favorable. Companies often extend the period of credit turnover, which lowers the ratio, but increases liquidity for the business. However, a ratio that is too low may indicate that the company is struggling to pay off its liabilities, and may reduce the creditworthiness of the business.
To find DPO, we divide 365 by the accounts payable turnover ratio, to determine the number of days it takes for a company to pay off its suppliers. Therefore, the formula for DPO is
Generally, it is more attractive to have a higher DPO, but not one that is too high. A high DPO means the company is efficient in extending the period of payment to the suppliers, but a DPO that is too high may mean the business is struggling and is unable to make the payments.
Analyzing the CCC
The CCC, as discussed before, can help you accurately determine the production/sales-related time of each dollar before it is converted into cash. It essentially measures the amount of time it takes for a company to empty its held inventory, convert an outstanding credit balance (A / R) into cash, and the length of time it takes to pay suppliers for goods/services received, and as with most cash flow calculations, smaller or shorter calculations are almost always good. Analyzing the CCC can help reveal useful information which may be blocking a certain company from efficient working capital management, such as not having tighter credit policies when extending credit to customers.
It can also be helpful to track an individual company's CCC over time, as it can demonstrate whether the business is becoming more or less efficient. Over time, monitoring CCC at regular intervals can help you see how a business is growing or improving, where a decreasing or steady CCC is a positive indicator to investors, as it means it takes less time to convert working capital into available cash. However, a rising CCC may be bad news, as it means the company is taking a long time to convert inventory into cash sales. The CCC can also be used to develop strategies to reduce the time it takes to sell inventory, collect credit, and make payments to suppliers.
The CCC metric takes into account the time it takes a business to sell its inventory, the time it takes to get paid credit extended, and the time it takes to pay bills. CCC is an important metric for companies purchasing and managing inventory as it is an indicator of operational efficiency and financial health. For example, a company with a high CCC may take a long time to collect payments from its customers, or it may be ineffective in forecasting demand for its products, which means it takes a long time to convert inventory into sales.
Let's illustrate this concept with an example.
Example of the CCC
You are hired as a financial analyst solely for the purpose of analyzing Strings Ltd's cash flow management performance in 2020 by measuring the CCC. The following information has been given to you:
The first step we will take is calculating DIO. As mentioned before,
Our next step is to calculate DSO. As mentioned before,
The final step is to calculate DPO. As mentioned before,
As CCC = DIO + DSO - DPO, therefore CCC = 138.7 + 73 - 50.69 = 161 days
It is clear that Strings Ltd's working capital management is lacking, as they are taking a long time to convert inventory into sales, as well as collect their accounts receivable, but are paying their suppliers quickly. This is a very negative sign to investors, as it indicates Strings Ltd is taking a long time to generate cash and might face insolvency and bankruptcy if not managed appropriately.
Check out the following video for further explanation on the CCC, as well as a detailed example
The CCC in Different Industries
It is important to note that the average money cycle can vary from sector to sector. While CCC is an important metric for large retailers who buy and manage inventory before selling to customers, it is not that important for companies across all industries. For example, companies that manufacture products before selling them may take longer to convert them into cash than a company that buys the off-the-shelf stock.
Since the CCC calculation includes an inventory conversion efficiency calculation, companies that do not maintain inventory may not need it. CCC works well for companies that have an inventory of physical assets, be they retail or manufactured goods. Large retailers are a typical example of a CCC score that can be understood a lot, while service industries that do not require much or any inventory at all, such as consulting, would not be analyzed by using the CCC, as the metric would be skewed. However, these industries that do not have inventory held up are still able to use DSO and DPO to analyze how efficient their company is at converting their accounts receivable into cash, as well as paying off its accounts payable.