For hardware-centric and procurement-heavy companies, managing cash flow efficiently is crucial to success. That's where the cash conversion cycle comes in. This metric measures the time it takes for a company to convert its investments in products and sales to cash.
By analyzing activity ratios such as inventory outstanding, cost of sales, accounts receivable, and accounts payable, companies can determine their cash conversion cycle and see how well they're using their working capital.
A shorter cycle indicates better performance, as it means the company is converting resources to cash faster. In this blog post, we'll explain the cash conversion cycle in-depth, including how to calculate it and use it alongside other important metrics like return on equity and turnover ratio. We'll also explore how companies can use the cash conversion cycle to evaluate their own performance and compare it to their competitors.
By the end of this post, you'll have a clear understanding of how the cash conversion cycle can simplify performance metrics and help your company improve its cash flow management.
Cash Conversion Cycle
The cash conversion cycle, or CCC, is the time needed by a company to convert money invested in products and sales to cash. This time is measured in terms of days. It is an important metric for companies because it allows them to see how efficient they are in using their working capital and managing their cash flow.
The cash conversion cycle needs a combination of several activity ratios to be determined. These activity ratios include:
- Inventory outstanding and sales
- Cost of sales
- Accounts receivable (AR)
- Accounts payable (AP)
The accounts receivable refers to the accounts that the company needs to collect payments from. Accounts payable mean the accounts companies need to make payments to. The average accounts is the balance of the AR in a certain period.
To sum it up, the cash conversion cycle is the time it takes to:
- Pay suppliers for goods and services then create an inventory
- Sell products then receive customer payments
The cash conversion cycle can also be defined as the time taken by a company to convert its investments in inventory to cash.
What is Inventory?
Inventory is a current asset account on the company balance sheet. It consists of finished goods accumulated by the company, raw materials and work-in-progress. The inventory for each period is determined by the volume of sales made within the period. Inventory is also the most illiquid of all resources. The inventory outstanding mentioned earlier is simply inventory that has not yet been sold.
The cash conversion cycle is closely tied to the inventory, so we need to keep all this in mind as we explain the CCC in-depth, and learn how to calculate it and use it.
Understanding The Cash Conversion Cycle: How Do We Calculate It?
We mentioned how the cash conversion cycle requires different activity ratios to be calculated. These ratios are obtained from the company’s financial statements as the following values from within certain periods:
- Average inventory cost over the period
- Cost of goods sold or cost of sales
- Accounts receivable balance
- Annual revenue
- Ending accounts payable
These are then used to determine the 3 values for calculating the cash conversion cycle formula:
- Days of inventory outstanding
- Days of sales outstanding
- Days of payables outstanding
Days of Inventory Outstanding
Days of inventory outstanding, or DOI, is the number of days taken to sell the whole inventory. It is calculated in two steps. First, calculate the average inventory cost:
--> (Beginning Inventory+Ending Inventory)/2
Then, use the value obtained to determine the days of inventory outstanding:
--> Average Inventory/Cost of Goods Sold
Days of Sales Outstanding
Days of sales outstanding, or DSO, is the number of days taken to collect sales profits.
Just like for days of inventory outstanding, days of sales outstanding are calculated in two steps. The first step involves calculating the average of the accounts receivable:
--> Average Accounts Receivable/2
Use the value obtained in this formula to get the days of sales outstanding:
--> (Accounts Receivable / Annual Revenue) x Number of Days in Period
Days Payable Outstanding
Also known as DPO, the days payable outstanding value shows how well a company pays its accounts payable(AP). When the days payable is at its best, it means the company is holding on to cash much longer enhancing its investment potential. Therefore, the longer the days payable, the better.
Days payable is calculated using this formula:
--> Ending Accounts Payable / (Cost of Sales / Number of Days)
Therefore, the cash conversion cycle formula is:
--> Days inventory outstanding + Days sales outstanding - Days payable outstanding
What Is A Good Cash Conversion Cycle Value?
Now that we know how to obtain the cash conversion cycle, what exactly does it mean? Cash conversion cycles vary depending on the type of industry a company is in, but the general rule is that the less number of days you need to convert resources to cash, the better. Therefore, the company with the lowest CCC is often the one using its resources best and the one worth investing in.
Another important concept to understand when interpreting the cash conversion cycle is the negative cash conversion cycle. When a company has a negative cash conversion cycle it means that its inventory is sold before it is paid for. Therefore, suppliers and vendors are essentially paying for business operations. This is a desirable situation for a company.
Now, how is the cash conversion cycle used?
How and Where to Use the Cash Conversion Cycle
On its own, cash conversion cycle values do not say much about cash flow or working capital management. It is best suited for use as a metric for comparison, or in conjunction with other metrics.
Cash Conversion Cycle Used in Conjunction with Other Metrics
The cash conversion cycle tells us more when it is used in conjunction with other metrics. Here are some of the most common metrics it is used alongside:
- Return on equity (ROE): this shows how good a company is at generating returns on the investments received from shareholders. A shorter cash conversion cycle means that the company has higher ROE and is thus profitable to invest with. It is calculated by dividing the net income by the shareholder's equity. This is not to be confused with the equity ratio. The equity ratio is a ratio that measures shareholder’s equity against a company’s total assets. It measures the amount of leverage used by a company.
- Return on assets (ROA): this shows how effective a company is in generating revenue from its assets. The cash conversion cycle has a negative relationship to ROA, meaning that a shorter CCC means that a company is good at generating revenue from its assets. Thus, it is a good company to invest in.
- Turnover Ratio: The turnover ratio is a measure of how effective a company is in extending credit and how well it collects debt. It is often defined in the same breath as the receivables turnover ratio, which is a measure of how well a company collects its accounts receivable. Faster debt collection, indicative of a positive turnover ratio, means a company holds on to its money and collects interests garnered from loans effectively. Therefore, faster collections of receivables mean a shorter CCC.
- Inventory Turnover: The inventory turnover shows how many times a company sells and replaces inventory over a set duration. A higher inventory turnover means a company has a shorter CCC.
Therefore, we can see that with most of these metrics, a negative correlation needs to exist between them and the cash conversion cycle. The shorter the CCC, the better the company is performing across different metrics.
Cash Conversion Used as a Measure of Comparison
As a measure of comparison, the cash conversion cycle is used to see how well a company is doing over time, or how well it is performing in comparison to its competitors:
Evaluating Company Performance
The cash conversion cycle is used to compare a company’s performance from one period to another.
For example, say a company had a CCC of 33 days in the fiscal year of 2018, then a CCC of 99 days in the following fiscal year. Such an increase in the CCC would indicate a decline in business operation efficiency.
The best thing for this company to do would be to do a careful audit of its operations to find out what happened. The company managers should look at what was done differently between the two years. What were the market and market and economic conditions for both years? What external or internal influences were unfavorable?
A clever thing to do is to go back to each of the calculations and values used to attain the CCC. It will be easier to identify the root cause of the change. You may find that it was an occasional setback like raw material shortages or even transport delays due to road construction. It may even have simply been customers or suppliers facing temporary financial challenges.
To get a wholesome picture of performance, it is useful to track CCC trends over several years. Comparing data taken over several years will help you see the direction in which a company is moving.
Finally, the cash conversion cycle is useful for seeing where you stand in comparison with industry competitors.
For this comparison to work, the CCC value being compared has to be taken for the same period and the business should preferably have the same model. Different business models may have different DOI, DSO or DPO values, giving a false image of success. For example, online companies do not pay suppliers before receiving payment for goods. They, therefore, do not hold inventory as long as other companies do but can hold on to their money for just as long.
These differences are why it is important to use CCC with other metrics.
For hardware-centric and procurement-heavy startups, effectively managing cash flow is crucial to success. The cash conversion cycle (CCC) is a valuable metric that can help these companies determine how efficiently they're using their working capital and managing their cash flow. In essence, the CCC measures the time it takes for a company to convert its investments in products and sales to cash.
To calculate the CCC, companies need to consider several activity ratios, including inventory outstanding, cost of sales, accounts receivable, and accounts payable. These ratios are obtained from the company's financial statements for a certain period, and are used to determine the days of inventory outstanding, days of sales outstanding, and days of payables outstanding.
A shorter cash conversion cycle is indicative of better performance, as it means that a company is converting resources to cash faster. Additionally, a negative cash conversion cycle is desirable, as it means that a company's inventory is sold before it is paid for, allowing suppliers and vendors to essentially pay for business operations.
In this blog post, readers will learn how to calculate the cash conversion cycle, how to use it alongside other important metrics like return on equity and turnover ratio, and how to evaluate their own performance and compare it to their competitors using the CCC. The post emphasizes that the CCC is best used in conjunction with other metrics, and provides examples of how it can be used for comparison over time or against industry competitors.
By the end of the post, readers will have a clear understanding of how the cash conversion cycle can help hardware-centric and procurement-heavy companies improve their cash flow management and overall performance.