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:
- Selling current inventory
- Collecting cash from current sales
- Paying vendors for goods and services purchased
As such, the CCC is calculated using three other working capital metrics: Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO). DIO and DSO are short-term assets, while DPO is classed as a liability.
Cash conversion cycle formula
The cash conversion cycle formula is as follows:
CCC = DIO + DSO – DPO
Where:
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
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.
