The cash conversion cycle is a key indicator for a company to show how quickly a company converts cash into inventory and then converts that inventory back into cash via sales. The faster a company makes a product and sells it, the more efficient that company is. The ideal situation is to have cash tied up in accounts receivable and inventory for as little time as possible. Moreover, if the time allowed for paying for materials and supplies (days payable outstanding or DPO) is increased then cash flow is further enhanced. It is the ideal situation for a company to quickly make and sell things and be able to delay payment for supplies. It is the ideal situation where cash flow ceases to be a problem.
How to Calculate the Cash Conversion Cycle
First a note on the terms used:
CCC = Cash Conversion Cycle
DIO = Days Inventory Outstanding; it measures the average number of days that a company holds inventory prior to a sale.
DSO = Days Sales Outstanding; it measures the number of days, on average, that a company takes to collect its accounts receivable.
DPO = Days Payable Outstanding; it measures, on average, how many days a company is taking to pay its suppliers.
The formula is as follows:
CCC = DIO + DSO – DPO
DIO is calculated by average inventory value/cost of goods sold x number of days
DSO is calculated by sum of accounts receivable (unpaid invoices from customers) x number of days/total credit sales
DPO is calculated by sum of accounts payable (what the company owes) x number of days/cost of goods sold.
So, if the DIO is 40 days, the DSO is 30 days and the DPO is 40 days
CCC = 40+30-40 = 30 days
All Important Context
There are a number of key factors to consider:
- Comparing the CCC of a company that makes aeroplanes with the CCC of a company manufacturing cars is not helpful. It takes much longer to build a plane than a car. More useful is to compare company CCCs in the same sector.
- A company that has managed to negotiate payment terms with suppliers so that they have a high DPO might create a low or even negative CCC score. However, that company might gain a reputation in its sector for being a slow payer. Thus, causing reputational damage. It might even deter some suppliers from wanting to do business with a company that takes a long time to pay up.
The cash conversion cycle identifies three financial levers: DIO, DSO and DPO. Change any of these three numbers and the CCC is altered.
Thus, a company should look at how to speed up production and how to sell its products faster. This could be achieved by scrutinising the production process; by investing in better technology to increase productivity; and by reducing waste in materials. So, DIO improvement involves improvements in both production systems and marketing.
DSO is a reflection of the amount of time it takes for customers to pay for products. Clearly, waiting 90 days for an invoice to be paid means a company has its money tied up when it could be put to better use. One way to reduce DSO is to use a factoring company that will release cash quickly back into the cash conversion cycle.
As has been mentioned, DPO can be a bone of contention. A big company that uses its size to bully smaller companies supplying them to accept long delays in payment is not going to be popular. However, a company can work with its suppliers, perhaps by participating in an early payment scheme such as invoice discounting. In this system a factoring company pays the supplier immediately and gives the buyer a longer period of time to settle the account.
When a company board meets it needs data to scrutinise; it needs numbers; it needs comparisons. The cash conversion cycle provides a number. The lower the number the better. A low number means cash flow is good, and the danger of running out of money is minimised.
The formula for CCC also highlights the possible areas where improvements can be made. Good analytics just as much as big ideas can keep a company profitable.