The Cash Conversion Cycle is a metric that represents the AVERAGE NUMBER OF DAYS it takes a business to get a dollar invested in its inventory back from a dollar of sales.
Understanding the Cash Conversion Cycle
Everything moves in cycles.
Think of the cycles of Nature or the Solar System.
A business is no different.
For any business that sells inventory, the MOVEMENT OF CASH ALSO HAPPENS IN A CYCLE.
To fully understand the Cash Conversion Cycle, one must first understand how cash flows in a business.
Cash goes out of the business to purchase inventory from suppliers. The inventory is then sold, and cash comes back into the business.
If you could neatly divide this movement of cash into stages, it would probably be
STAGE 1: The cash is invested in inventory (often becoming a PAYABLE to a supplier).
STAGE 2: The inventory gets sold (often on credit and the cash gets converted into a RECEIVABLE).
STAGE 3: The receivables get collected, and the cash comes back to the company.
Once cash comes back into the company, this process repeats itself.
Do this many times over, and you have a functioning business.
The average number of days this cycle takes to complete once is called the Cash Conversion Cycle.
Knowing this number is vital for business owners since it gives them a yardstick to improve efficiency in their processes as well as compare their business to peers.
Let's take a look at how we calculate it.
Formula of the Cash Conversion Cycle (CCC)
Accountants and Analysts have packed this general concept neatly into a formula.
CCC = DIO + DSO - DPO
DIO stands for Days Inventory Outstanding
DSO stands for Days Sales Outstanding,
and DPO Stands for Days Payable Outstanding
What is Days Inventory Outstanding?
Days Inventory Outstanding is a financial ratio that indicates the average number of days it takes a company to sell its inventory.
What are Days Sales Outstanding?
Days Sales Outstanding is a financial ratio that indicates the average number of days it takes a collect on its receivables after the inventory has been sold.
What is Days Payable Outstanding?
Days Sales Outstanding is a financial ratio that indicates the average number of days it takes a company to pay back its suppliers.
Let's take a look at an example to understand the Cash Conversion Cycle better.
Example of the Cash Conversion Cycle
Superpower Inc. purchases inventory on 45 days credit.
It takes 60 days on average to sell its inventory. Once the inventory is sold, it takes approx 30 days to collect payments from buyers.
Using the Cash Conversion Cycle Formula we get
CCC = DIO + DSO - DPO
= 60 + 30 - 45
= 45 days.
Superpower Inc. has a cash conversion cycle of 45 days.
If Superpower Inc. decides to prolong its payments to Suppliers to 55 days instead of 30, the cash conversion cycle will improve to
= 60 + 30 - 55 = 35 days.
Why is the Cash Conversion Cycle important?
The Cash Conversion cycle is an important metric to measure the health of a Business, especially when doing a cash flow or working capital analysis.
All else being equal, business owners would prefer having a shorter Cash Conversion cycle since it means they would get the money they invest into inventory back faster.
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