What Is the Cash Conversion Cycle (CCC)?
The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC attempts to measure how long each net input dollar is tied up in the production and sales process before it gets converted into cash received.
This metric takes into account how much time the company needs to sell its inventory, how much time it takes to collect receivables, and how much time it has to pay its bills.
The CCC is one of several quantitative measures that help evaluate the efficiency of a company’s operations and management. A trend of decreasing or steady CCC values over multiple periods is a good sign while rising ones should lead to more investigation and analysis based on other factors. One should bear in mind that CCC applies only to select sectors dependent on inventory management and related operations.
The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash, or the capital investment, as it is first converted into inventory and accounts payable (AP), through sales and accounts receivable (AR), and then back into cash. Generally, the lower the number for the CCC, the better it is for the company. Although it should be combined with other metrics (such as return on equity (ROE) and return on assets (ROA), the CCC can be useful when comparing close competitors because the company with the lowest CCC is often the one with superior management. Here’s how the CCC can help investors evaluate potential investments.
Understanding the Cash Conversion Cycle (CCC)
The CCC is a combination of several activity ratios involving accounts receivable, accounts payable, and inventory turnover. AR and inventory are short-term assets while AP is a liability. All of these ratios are found on the balance sheet. In essence, the ratios indicate how efficiently management is using short-term assets and liabilities to generate cash. This allows an investor to gauge the company’s overall health.
How do these ratios relate to business? If a company sells what people want to buy, cash cycles through the business quickly. If management fails to realize potential sales, the CCC slows down. For instance, if too much inventory builds up, cash is tied up in goods that cannot be sold—this is detrimental to the company. To move inventory quickly, management must slash prices, possibly selling its products at a loss. If AR is poorly managed, the company may be experiencing difficulty collecting payment from customers. This is because AR is essentially a loan to the customer, so the company loses out whenever customers delay payment. The longer a company has to wait to be paid, the longer that money is unavailable for investment elsewhere. On the other hand, the company benefits by slowing down payment of AP to its suppliers because the extra time allows it to make use of the money longer.
The Formula for Cash Conversion Cycle (CCC)
Since CCC involves calculating the net aggregate time involved across the above three stages of the cash conversion lifecycle, the mathematical formula for CCC is represented as:
CCC = DIO + DSO − DPO
DIO – Days of inventory outstanding (also known as days sales of inventory)
DSO – Days sales outstanding
DPO – Days payables outstanding
DIO and DSO are associated with the company’s cash inflows, while DPO is linked to cash outflow. Hence, DPO is the only negative figure in the calculation. Another way to look at the formula construction is that DIO and DSO are linked to inventory and accounts receivable, respectively, which are considered as short-term assets and are taken as positive. DPO is linked to accounts payable, which is a liability and thus taken as negative.
Days Inventory Outstanding (DIO)
Days Inventory Outstanding (DIO) is the number of days, on average, it takes a company to turn its inventory into sales. Essentially, DIO is the average number of days that a company holds its inventory before selling it. The formula for days inventory outstanding is as follows:
For example, Company A reported a $1,000 beginning inventory and $3,000 ending inventory for the fiscal year ended 2021 with $40,000 cost of goods sold. The DIO for Company A would be:
Therefore, it takes this company approximately 18 days to turn its inventory into sales.
Days Sales Outstanding (DSO)
Days Sales Outstanding (DSO) is the number of days, on average, it takes a company to collect its receivables. Therefore, DSO measures the average number of days for a company to collect payment after a sale. The formula for days sales outstanding is as follows:
For example, Company A reported $4,000 in beginning accounts receivable and $6,000 in ending accounts receivable for the fiscal year ended 2021, along with credit sales of $120,000. The DSO for Company A would be:
Therefore, it takes this company approximately 15 days to collect a typical invoice.
Days Payable Outstanding (DPO)
Days Payable Outstanding (DPO) is the number of days, on average, it takes a company to pay back its payables. Therefore, DPO measures the average number of days for a company to pay its invoices from trade creditors, i.e., suppliers. The formula for days payable outstanding is as follows:
For example, Company A posted $1,000 in beginning accounts payable and $2,000 in ending accounts payable for the fiscal year ended 2021, along with $40,000 in cost of goods sold. The DPO for Company A would be:
Therefore, it takes this company approximately 13 days to pay for its invoices.
Putting it Together: Cash Conversion Cycle
Recall that the Cash Conversion Cycle Formula = DIO + DSO – DPO. How do we interpret it?
We can break the cash cycle into three distinct parts: (1) DIO, (2) DSO, and (3) DPO. The first part, using days inventory outstanding, measures how long it will take the company to sell its inventory. The second part, using days sales outstanding, measures the amount of time it takes to collect cash from these sales.
The last part, using days payable outstanding, measures the amount of time it takes for the company to pay off its suppliers. Therefore, the cash conversion cycle is a cycle where the company purchases inventory, sells the inventory on credit, and collects the accounts receivable and turns them into cash.
Using the DIO, DSO, and DPO for Company A above, we find that our cash conversion cycle for Company A is:
CCC = 18.25 + 15.20 – 13.69 = 19.76
Therefore, it takes Company A approximately 20 days to turn its initial cash investment in inventory back into cash.
Interpreting the Cash Conversion Cycle
The CCC formula is aimed at assessing how efficiently a company is managing its working capital. As with other cash flow calculations, the shorter the cash conversion cycle, the better the company is at selling inventories and recovering cash from these sales while paying suppliers.
The cash conversion cycle should be compared to companies operating in the same industry and conducted on a trend. For example, measuring a company’s conversion cycle to its cycles in previous years can help with gauging whether its working capital management is deteriorating or improving.
In addition, comparing the cycle of a company to its competitors can help with determining whether the company’s cash conversion cycle is “normal” compared to industry competitors.
Cash Conversion Cycle Analysis
Determining a company’s cash conversion cycle involves many activity ratios. These ratios reflect AR, AP, and inventory turnover. All of these can be found in the balance sheet. But how exactly do these ratios impact business?
If a company sells products that people are looking for, cash cycles go faster. If the company cannot tell which products sell, cash cycles slow down. For example, when a huge excess of inventory builds up, money gets stuck in items that could not be sold. This is bad for business.
To move inventory faster, the company may have to offer discounts or even sell the inventory at a loss. Poor AR handling can indicate that the business is having a hard time getting customers to pay. That’s because AR is practically a loan to the customer, which means if the customers stall payment, the company ends up with a loss. The longer it takes for a business to receive the payment, the longer that money stays non-liquid and unavailable for reinvestment.
On the other hand, if the company holds off payments to its AP suppliers, it can benefit from being able to use the money for longer and making a bigger profit.
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.
How to Shorten Your Cash Conversion Cycle (Sustainably)
To shorten your CCC, you should closely monitor and improve working capital metrics like DSO, DIO, and DPO. However, it’s important to note that many of the obvious steps for improving these actions can end up hurting you in the long run if taken too far.
For example, extending the amount of time you have to pay vendors helps extend DPO. So it’s the first place many businesses will make changes. However, delaying payments to vendors too much can damage your business relationships and impact their ability to provide the goods or services you require to produce your own.
Similarly, ramping up cash collections from customers will help improve DSO. But aggressive cash collection could damage relationships with customers and result in a loss of business. Not to mention, aggressive cash collection is time-consuming and cost-intensive, which reduces the overall benefit of obtaining a shorter CCC in the first place.
We’re not saying these methods for improving your cash conversion cycle are bad. In fact, revisiting payment terms with customers and vendors is an essential part of improving your cash conversion cycle. However, they should be optimized incrementally over time (and balanced with other actions, outlined below) rather than used as a short-term stopgap.
1. Evaluate Vendor Health and Stability
Reliable vendors make it easier to optimize production and the rest of your supply chain in order to minimize your cash conversion cycle. For example, if you can count on a vendor to deliver when they say they will, it makes it easier to optimize production campaigns in order to reduce the amount of time inventory sits before it’s sold.
Financially healthy vendors also help reduce the risk of supply chain disruptions that could impact your bottom- and top-line revenues.
2. Evaluate Invoicing and Accounts Receivable Processes
If it’s hard for your customers to pay you, it will generally take longer for them to do so. So to shorten your DSO and cash conversion cycle, it’s important to regularly review your accounts receivable and invoicing processes to ensure they work for your customers.
Make sure your invoices are accurate, contain all of the information your clients need, and are sent on time. Use electronic payments, if possible, to streamline the payment process.
3. Reassess Customer Credit Criteria
Customers with healthy, stable businesses are more likely to pay you on time. So revising the customer credit criteria and the policies for new customers can improve the quality of the customers you engage with and help reduce the amount of time it takes to get paid.
Be sure to consult your sales and customer success teams about any changes you make to customer payment terms, credit changes, or payment processes. You’ll want to ensure any changes you make won’t impact their ability to close deals or retain clients.
4. Streamline Inventory Management Processes
Reducing the amount of time it takes for inventory to turn over will reduce your cash conversion cycle. For this reason, many businesses adopt a “just-in-time” approach to inventory management to minimize the amount of time inventory sits before selling.
However, while reducing the amount of time inventory sits is a key part of streamlining inventory turnover, there is a limit to how “just-in-time” inventory replenishment can be before a single disruption could wreck your top- and bottom-line revenues. For example, if a raw material input arrives late to the production process, the entire production of the finished product could be delayed or halted, which could impact customer relationships.
Instead, it’s better to hold more stock and reassess your demand forecasts on a regular basis with historical data to ensure production campaigns and replenishment timing are both optimized without putting the business at risk.
Operating Cycle vs Cash Conversion ycle
What is the difference between operating cycle and cash conversion cycle? In simple terms, the operating cycle refers to the duration (in days) between when you buy inventory and when your customers pay for that inventory. The cash conversion cycle, on the other hand, measures the number of days between when you pay for inventory and when your customers pay you for the same inventory.
What does the operating cycle indicate? This metric estimates the amount of working capital that your business needs in order to grow or maintain. If your operating cycle is short, then it means you require less cash to run operations. The business can still grow even if you’re selling inventory at small profit margins.
Understanding Cash Conversion Cycle & Cash Flow
Simply put, the cash conversion cycle measures the amount of time it takes for a business to turn inventory into cash. It’s at times referred to as the cash-to-cash cycle because it estimates the period between when you pay for inventory and when customers pay for the same inventory.
Customer payments replenish your company’s cash flow. If they take too long to pay invoices, it means that most of your cash and working capital will be tied up. This may prevent you from taking up new customers, particularly if your business works with heavy inventory demands (like a construction company).
The bottom line is, the cash conversion cycle will give you an idea of how long it takes for your business to collect cash payments from customers. It, therefore, helps you determine whether the process of cash flowing in and cash flowing out is efficient. A low CCC cycle creates a positive cash flow while a high CCC cycle puts you at risk of a negative cash flow. This is what makes it very important to keep a keen eye on your business’s cash conversion cycle.
Why is a Good Cash Conversion Cycle Important?
A good cash conversion cycle is important primarily because it signifies that a company’s inventory chain is running efficiently. As already mentioned, your CCC is good if it’s low. On the other hand, if your company’s CCC is high, then it means that you have either inventory or financial management issues. Either of these two can cause serious cash flow problems.
Financial, inventory and cash flow efficiencies are not the only reasons why a good cash conversion cycle is important. Here are some more:
Improves business operating efficiency: pushing your CCC cycle low indicates that you’re doing a great job at converting inventory into cash. This, in turn, means that your business is operating efficiently. On the other hand, a high cash conversion cycle could imply operational challenges, a decline in your market niche or a lack of demand for your products. Whatever the case, a bad CCC implies that there’s an issue that needs correcting for your business to run efficiently.
Better terms for trade lines: some suppliers will look at your cash conversion cycle when deciding whether or not to give your company trade lines. If your CCC is low, then it means that your business has sufficient liquidity. In which case, suppliers and vendors won’t worry about extending tradelines to you.
Easier access to loans and capital: a good cash conversion cycle doesn’t just increase your chances of getting trade lines, it also improves the likelihood of getting approved for business loans. The reason behind that is simple. If you have a low CCC, then your business’s liquidity is healthy. To lenders, this means that you can comfortably pay back loans that are advanced to you. Such a sense of security increases their likelihood of approving your loan applications.
Good debt management: as already mentioned, the CCC of a company has an influence on its cash flow. By analyzing this measure, you can correctly determine whether your company is strapped for cash or if you have enough of it. Thus, it can help you figure out whether or not to ask lenders for money and how much of it to ask for.
Cash Conversion Cycle Conclusion
- The cash conversion cycle is a metric that reveals how fast a company’s inventory moves until it is converted to cash.
- The cash conversion cycle formula requires three variables: Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO), and Days Payable Outstanding (DPO).
- The results of the CCC is expressed as the number of days.
- The cash conversion cycle is of little value by itself but could be a game-changer when used to compare how fast inventory moved between two or more periods, and when making decisions to improve future inventory movements.