Every company needs healthy cash flow. And if you buy and sell inventory on account, then you’ll need to know how long it takes to turn that inventory into cash.
That’s the cash conversion cycle, and it’s key to making sure you’re on top of your company’s working capital.
What is the Cash Conversion Cycle?
The cash conversion cycle (CCC) tells you how many days it takes for your company to turn your inventory purchases into cash. You acquire inventory from a supplier, store that inventory, sell it to a customer on account, pay your suppliers and collect on your invoices — getting paid and putting cash back into the company.
The CCC is an important financial indicator of your company’s cash flow. It shows your ability to maintain highly liquid assets and is a metric that lenders and other finance providers will use to assess your potential risk level.
The formula follows your cash through these various stages:
- Inventory Purchase, Transport and Storage
- Accounts Payable and Payments to Suppliers
- Sales, Accounts Receivable and Collections
How to calculate the Cash Conversion Cycle
There are three numbers you’ll need to complete the basic CCC formula, all of which you can derive from your financial statements.
CCC = DIO – DPO + DSO
Let’s look at each component a little more closely.
- DIO: Days Inventory Outstanding.
- This is the number of days on average that your company turns your inventory into sales. The smaller this number, the better.
- DPO: Days Payable Outstanding.
- This is the number of days it takes you to pay your accounts payable. The higher this number, the longer you can hold onto cash, so a longer DPO is better.
- DSO: Days Sales Outstanding.
- This is the number of days you’ll need to collect on the sales of that inventory after the sale has been made. Again, the lower the number, the better.
So the CCC is equal to the number of days it takes to sell your inventory, plus the number of days you need to collect on your sales, minus the days it takes you to pay your vendors.
Keisha runs an industrial supply company. Keisha always pays her supplier within 30 days. She keeps enough inventory on hand to satisfy 60 days of sales and is good at managing this. It will take 52 days on average for her customers to pay their invoices. This would be her CCC formula:
CCC = 60 days – 30 days + 52 days
CCC = 82 days
Keisha’s CCC is 82 days, meaning that she will need on average 82 days of working capital to convert purchased inventory into cash.
The above is a simplified example, and to get accurate results you must calculate and track your DIO, DPO and DSO on a monthly, quarterly or annual basis, along with the dollar values for inventory and sales.
What CCC teaches you & how to make adjustments
The CCC will give you an indication of your cash liquidity position — and it can point your attention to what is helping or hindering your cash flow. Depending on the results, you may determine immediate areas that can be improved.
The longer the CCC, the more working capital you’ll need to manage your operations. And that can be an overwhelming challenge for many businesses. Generally speaking, companies want to shorten their CCC.
To shorten the CCC, you may be able to manage inventory levels better, get longer supplier payment terms, improve your collection process or adjust the payment terms you give your customers. However, this may not always be practical or something you’re wanting to change for a number of reasons.
Instead, you can use financing such as Accounts Receivable Financing — also known as factoring — to lower the CCC by turning accounts receivable into cash faster. This is where our company has been able to help businesses increase their cash flow. Using factoring you can effectively lower your DSO, which means you will get paid on your sales faster and have quicker access to working capital. That cash can be reinvested into your company faster than if you had to wait on all invoices to be paid out according to the usual payment terms.
Or you could get extended payment terms from suppliers to reduce the DPO portion of the formula or use financing tools such as Purchase Order Financing to help you make up the gap where suppliers are not providing adequate or any terms. By extending the number of days you have to pay your accounts payable, you can keep cash in the company and effectively increase your working capital.
However, the CCC alone cannot be a complete indication of liquidity. You’ll need to look at calculating other liquidity metrics like the current ratio and quick ratio to paint a complete picture. You may already have these calculations in place, but if you haven’t yet calculated your cash conversion cycle, it’s time to start crunching the numbers and tracking changes over time to manage your business better.
This is the first part of our cash conversion cycle series. We’ll be writing about practical ways to reduce your DSO and DIO, stretch your DPO and how service providers can use the CCC when ‘inventory’ doesn’t apply to their business.
Originally published September 26, 2016.