Cash Conversion Cycle

The cash conversion cycle (CCC) is a measurement of the time it takes for a business to convert initial investments into eventual cash flow from sales.

All businesses must make upfront investments into resources to make their operation work on a day-to-day basis. Depending on the nature of the business, this will include things like supplies, materials, and product inventory.

Eventually, these resources will be converted into a product that the business can market and sell. How long it takes for this process to complete, and for the business to collect revenue from the resulting sales, is an important metric for the business.

Sometimes referred to as the net operating cycle or simply cash cycle, CCC is a measurement of how long each dollar inputted into the process is engaged before it gets converted into cash that the business can then use to invest in new resources and growth.

The length of the cycle reflects the efficiency and performance of the business. In simple terms, typically the shorter the cycle, the better. Although, this can vary depending on the nature of the business.

The formula for calculating the CCC consists of three component metrics:

Days Inventory Outstanding (DIO) is a metric that reflects how long it takes for a business to sell its inventory.

It is calculated by dividing the average (or ending) inventory balance by the cost of goods sold (COGS) and multiplying the result by the number of days in the period, typically 365 days for one year.

The average inventory is calculated by adding the value of inventory at the beginning of the period to the value at the end of the period and dividing this number by two.

The cost of goods sold is a measurement of all the direct costs related to the production of an item that is sold by the business. This includes all materials and labor that go into the production of that item.

Calculating the average inventory as a fraction or proportion of the total cost of goods sold and multiplying this number by the total number of days in a year (or whatever period is being measured) produces a figure that reveals how long it takes for the business to sell its inventory of products within that period.

Days Sales Outstanding (DSO) is a formula that measures the average number of days it takes a business to collect payment for products or services provided. It is calculated by dividing the value of accounts receivable by the total number of sales on credit. This product is then multiplied by the number of days in the reporting period. The equation is represented mathematically as:

(Accounts Receivable ÷ Credit Sales) x Number of Days = DSO

The result of this calculation represents the average amount of time it takes during the accounting period for accounts receivable, or credit sales, to be collected.

The third metric, Days Payable Outstanding (DPO), is calculated by dividing accounts payable, or outstanding bills to suppliers and vendors, by the Costs of Goods Sold and multiplying the result by the number of days in the cycle.

This metric indicates the average number of days it takes for a company to pay its invoices from creditors or suppliers.

The three metrics described above are combined into one formula to calculate the CCC. Mathematically, this calculation is represented as:

DIO + DSO – DPO = CCC

In other words, the formula adds the rate at which inventory is sold to the rate at which sales revenue is collected, then subtracts the rate at which bills are paid.

The resulting sum reflects how long it takes for the business to convert its investments into resources and materials into cash revenue from sales.

The CCC is an important metric that reflects on the efficiency of a business. In a basic sense, it reveals how long it takes for a business to convert its upfront investments into cash revenue. The longer this process takes, the less efficiently the business is performing.

Breaking down this metric according to its component parts, the CCC may be indicative of many things. Asthe formula itself consists of several metrics, the result may be an indicator of one or many specific patterns or issues.

For example, because DIO is one of the component measures, the CCC may reflect on the business's ability to convert its inventory into sales and revenue.

Similarly, because the calculation includes the DSO, the result may be indicative of the effectiveness of credit management, or more specifically, how long it takes for the business to collect payments from customers who buy on credit.

Finally, the DPO metric indicates how long the business takes to pay creditors and suppliers, which itself reflects various other accounting processes within the business.

Stepping back to broader evaluations, the CCC is one of many indicators of the overall health of the business. It serves as an important metric for investors, lenders, creditors and suppliers alike, and can help shape the terms of capital, finances, and payment arrangements that are extended to the business.

The CCC can vary depending on the type of business that is being evaluated. In simple terms, a shorter CCC is better. Most businesses would prefer to minimize the amount of time inventory stays on the shelves as well as the time it takes to collect payment from customers. The consensus for an ideal CCC ranges between 30 and 45 days.

Some businesses move products faster than others, but that doesn’t necessarily mean they have a better CCC when you factor in industry differences. For example, retail businesses tend to have shorter CCCs because they move their products quickly - while manufacturing businesses will have a longer period before they see cash flow.

Since the CCC considers various processes, a business can take steps to improve this metric in many different ways. For example, if your worst metric is the DIO, you may want to take steps to move inventory more quickly and efficiently.

If DSO is the variable causing your CCC to be high, you should take steps to improve collections of accounts receivable. Finally, if DPO is raising your CCC, then you should strive to improve the timeliness in which you pay creditors and suppliers.