The cash conversion cycle is an essential accounting metric that evaluates how long a company turns its inventory and other resource investments into cash. The process starts when a corporation buys merchandise and concludes when it gets money from clients in exchange for its sold goods.
Understanding the cash conversion cycle allows organizations to manage resources and ensure enough cash flow for day-to-day operations.
Taking action to improve your company’s CCC over time can increase cash flow, streamline operations, and create a more stable platform for growth if your company controls inventory, extends credit to customers, and receives credit from suppliers.
What is Cash Conversion Cycle?
The cash conversion cycle (CCC) quantifies the time necessary to turn resources into cash. This metric assesses how long invested funds are committed to the production and sales processes. A CCC with a short time enables a business to function with a minor initial cash input.
Inventory Conversion Period, Accounts Receivable Conversion Period, and Accounts Payable Conversion Period are the three major components of the cash conversion cycle. The Inventory Conversion Period is when a corporation purchases, sells, and collects money for that inventory.
The Accounts Receivable Conversion Period is the time between the sale of products and the receipt of payment from customers. The Accounts Payable Conversion Period is the time between when a business pays for items and when it receives reimbursement.
The cash conversion cycle aims to shorten the time it takes for a company to convert its investments into cash, increasing liquidity and enhancing its overall financial health. Companies may improve their productivity and guarantee they have the funds to meet their financial obligations by improving the cash conversion cycle.
What is the Concept of CCC in Accounting?
The cash conversion cycle is an integral concept of cash flow management.
The CCC measures the rate at which a business turns on hand into inventory and back into cash. Why is this crucial? Because determining the length of this cycle helps you to calculate the number of days during which your company’s money will be unavailable for investment.
The shorter your cash conversion cycle, the better, which indicates that cash is moving through your organization more quickly. The quicker you sell your goods, the lower your average days’ inventory, so make sure you don’t over-order or allow it to gather dust from being stored for too long.
The faster you recover your accounts receivable, the lower your average days receivable will be, and the sooner you will have access to this cash for your firm.
The longer your average days payable, the more your suppliers are financing your firm, which is beneficial but remember not to push them too far.
The three factors used to obtain the cash conversion cycle includes:
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The average time required for supplier payables to be completed
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The average time needed to convert raw materials into finished goods
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The average time required for collecting customer receivables
Calculating Your Cash Conversion Cycle
To calculate your cash conversion cycle, you must first specify the period you desire to use. Most organizations will have sufficient cash flow data to compute over thirteen weeks accurately.
The following information is required from your income statements and balance sheets:
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Revenue for the designated period
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Value of inventory from the beginning to the end of the period
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Cost of goods sold during that period
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Accounts payable from the beginning to the end of the period
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Accounts receivable from the beginning to the end of the period
Using the cash conversion cycle formula and this data, we will compute the various metrics required to estimate your cash conversion cycle.
Cash Conversion Cycle Formula
Because CCC entails calculating the net aggregate time involved in the three stages mentioned above of the cash conversion life cycle, its mathematical formula is as follows:
CCC = DIO + DSO – DPO
Cash conversion cycle = Days of inventory outstanding + Days sales outstanding – Days payables outstanding
Furthermore, to compute the following components, we have:
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DIO = Average inventory / (Cost of goods sold x number of days)
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DSO = (Accounts receivable x number of days) / total credit sales
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DPO = (Accounts payable x number of days) / cost of goods sold
DIO and DSO are related to cash inflows, but DPO is associated with cash outflows. DPO is, therefore, the only negative number in the calculation.
DIO and DSO are tied to inventory and accounts receivable, respectively, which are seen as short-term assets and are interpreted as positive. DPO is related to accounts payable, which is a liability and is therefore recorded as a liability.
Commonly, the entire CCC is known as the Net Operating Cycle. It is “net” because the amount of days of outstanding payables is subtracted from the Operating Cycle. It is because accounts payables are seen as a source of operating cash or working capital for the organization. In contrast, accounts receivables, or cash the company has not yet received, reduce the company’s available working capital for financing operations.
Days of Inventory Outstanding
DIO is comparable to DSO, but instead of comparing sales per day to average receivables, it compares the cost of goods sold per day to average inventory levels. The formula would appear as follows:
Days of Inventory Outstanding = [(Beginning Inventory + Ending Inventory) / 2] / (Cost of Goods Sold / 365)
DIO, also known as Days of Inventory on Hand, indicates the average number of days inventory has been on the shelf. In general, you want to see your product skyrocketing off the shelves. A lower quantity is preferable, but not so low that you don’t have enough inventory and miss out on sales opportunities.
Days of Sales Outstanding
The Days Sales Outstanding (DSO) metric is calculated by dividing the average Accounts Receivable by daily Revenue.
As a reminder, whenever we employ ratios that combine Balance Sheet (Accounts Receivable) figures with Income Statement (Revenue) data, we should average the beginning and ending Balance Sheet values. It is because the Income Statement tracks activity over the entire period. Still, the Balance Sheet reflects the value of the various accounts on a particular day (usually at the end of the period).
Accounts Receivable at the beginning of the term would be added to Accounts Receivable after the period and then divided by two. Similarly, Revenue per day would be Revenue divided by 365. Thus, the formula would be:
Days of Sales Outstanding = [(Beginning Accounts Receivable + Ending Accounts Receivable) / 2] / (Revenue / 365)
DSO indicates the average number of days customers pay you after a sale. You would prefer to receive payment right away from your clients. Therefore a lower figure is preferable, though businesses must always consider this in context. You don’t want your consumers to pay so promptly that they switch to competitors with less aggressive collection policies.
Days of Payables Outstanding
DPO is the last component of the Net Operating Cycle and is deducted from the Operating Cycle, thus the term “net.” It quantifies the days a company’s Accounts Payable are past due relative to its inventory purchases or Cost of Goods Sold. The formula for this is:
Days of Payables Outstanding = [(Beginning Accounts Payable + Ending Accounts Payable) / 2] / (Cost of Goods Sold / 365)
Days of Receivables Outstanding indicates the number of days the business takes to pay its suppliers. Contrary to the other two components of the Operating Cycle, the company wishes to extend the time it takes to settle for its inventory.
In reality, it is vendor financing that is free and free is excellent. However, it is dependent on the environment of each organization. For instance, the corporation wouldn’t want to pay so slowly that it missed out on early payment discounts or incentives, if any, are available.
Operating Cycle
The initial two components of the cash conversion cycle, DSO and DIO, comprise what is known as the Operating Cycle. It is the number of days it takes for a business to process raw materials and its inventory and receive payment for a sale.
Operating Cycle = Days of Sales Outstanding + Days of Inventory Outstanding
Essentially, the Operating Cycle indicates an item’s period from being in inventory to getting payment following a sale. You want this figure to be low, showing that the product is not wasting away on the shelves for too long and that consumers are paying immediately.
Importance of Cash Conversion Cycle in Accounting Practice
One of the most significant measures of a company’s operational effectiveness and financial health is its cash conversion cycle. It assists in guiding choices on the most effective use of a business’s resources, such as inventory levels and financing possibilities, maximizing profitability.
Businesses can more efficiently organize their operations to cut costs and boost profitability by knowing how long it takes to turn resources into cash. Additionally, it aids in identifying any issues the business may be having with client payment collection or the effective use of resources to generate income.
The CCC increases when a company takes too long to recover outstanding invoices, maintains too many goods on hand, or pays its debts too quickly. A lengthier CCC implies it will take longer to earn cash, which could lead to small businesses going bankrupt.
The CCC shortens when a company collects past-due payments quickly, accurately estimates inventory needs, or pays invoices slowly. A lower CCC signifies better business health. Businesses might then use the excess money for new purchases or debt reduction.
A strain on liquidity occurs when a manager must immediately pay its suppliers; it is harmful to the business. A drag on liquidity occurs when a manager cannot collect payments promptly, which is also detrimental to the company.
How to Utilize Cash Conversion Cycle for Your Business’s Success
The cash conversion cycle is meaningless on its own. Instead, businesses should measure how much a company has improved over time and compare it to its competitors.
During an analysis, the CCC can help compare competitors and should be used with other measures, such as return on equity (ROE) and return on assets (ROA). The corporation with the lowest CCC typically, although not always, makes better use of its resources.
Businesses can use the CCC to affect several operational and policy decision-making plans, which include:
Installing an efficient system to lessen the inventory investment.
Depending on how aggressively a business implements this plan, a firm can reduce the number of raw materials on hand to only what is urgently required on its manufacturing lines.
Outsource production to refrain from focusing on inventory investments.
It might result in a significant decrease in the amount of cash needed. It also enables the company to eliminate all its fixed asset investments in the producing region and related real estate.
Reinforcing the business’ credit policy to lower customer billings and have them pay on time
It, however, may turn away clients who may otherwise have added to the company’s profitability but had slightly worse credit. So, carefully craft the policy to make it beneficial for both sides.
Canceling products that are not selling well will eliminate related inventory amounts.
But doing so would leave gaps in the business’s product lineup, which might turn away customers. Develop a backup plan to bring out a product that will succeed in sales.
Negotiating with providers and suppliers to adjust their payment terms.
However, a typical result of this approach is that suppliers request slightly higher pricing in return, which reduces the overall impact.
It is desirable to have a short cash conversion cycle to operate a business with less cash. A company with a shorter CCC than its competitors reached this stage after reviewing the entire process repeatedly over an extended period of time.
At the very least, the conversion cycle should be tracked on a trend line, which should act if the cycle shows that it is taking longer to convert invested assets back into cash.
Smaller businesses with less debt or equity funding also closely monitor their cash conversion cycle. These companies must be careful with their cash usage because they don’t have much extra money. Nonprofit organizations are particularly vulnerable to this problem because they typically have limited cash reserves.
Analyzing Cash Conversion Cycle
The CCC counts the number of days it takes a business from when it first spends cash on inventory until it receives payment from a customer. For instance, a typical store purchases inventory from its suppliers on credit. When the merchandise is purchased, customers won’t pay the cash for some time afterward.
The funds are collected in full within the first thirty days, after which the business advertises the inventory to customers in preparation for sale to a client on the account. The consumer is responsible for paying for the stock within thirty days of the transaction.
The cash conversion cycle keeps track of the number of days that pass between when the retailer pays the vendor for the goods and when the customer pays them.
Smaller or shorter calculations are typically better, as is the case for most cash flow estimates. A shorter conversion cycle means that a company retains the money in inventory for less time. In other words, a business with a short conversion cycle may purchase merchandise, sell it, and collect payment from clients faster.
It can be considered a computation of sales efficiency in this way. It demonstrates the speed and effectiveness with which a business can acquire, sell, and collect goods.
How Can You Tell if Your CCC Is Good?- Cash Conversion Cycle
No single number encapsulates a “good” or “poor” cash conversion cycle because the average length of the cycle will fluctuate significantly among businesses.
Comparing the CCC of two firms operating in the same sector might be helpful, as a lower CCC might suggest that one business is managing its working capital more skillfully than the other.
Tracking a company’s CCC over time can also be beneficial because it can show whether the company is getting more or less efficient.
Because the CCC considers DIO, DSO, and DPO, a high (bad) CCC may indicate specific problems. For instance, a business with a high CCC may take a long time to get payments from clients or struggle to predict demand for its goods, making it challenging to turn inventory into sales. A high or rising CCC may also indicate that a corporation is not using its short-term assets most.
Negative CCC Meaning- Cash Conversion Cycle
Even though the cash conversion cycle is often positive, some businesses may have a negative cash conversion cycle. In this instance, the company receives money for the products it sells before paying its material suppliers. Businesses can accomplish it by simultaneously selling inventory quickly, getting buyers paid immediately, and paying the company’s suppliers later. With highly effective internet shops, a negative cash conversion cycle is typical.
When there is a negative cash conversion cycle, you sell the inventory before you have to pay for it. Or, to put it another way, your suppliers are paying for your company’s activities.
For many organizations, a negative cash conversion cycle is ideal. However, most organizations find achieving without resorting to drastic measures challenging. Therefore, it is preferable to concentrate on reducing your cash conversion cycle sustainably and benchmarking to see how you are doing rather than trying to drive it into the negative or even zero.
Cash Conversion Cycle Problems and Solutions
CCC is a beneficial tool for determining how quickly or slowly a company may convert inventory into cash; however, businesses must consider a few constraints.
The outcome of the calculation is contingent on several different variables. Getting even one of the variables wrong might throw off the fundamental analysis, affecting how the company chooses to proceed.
As a result, the DIO, DSO, and DPO calculations must be performed with extreme care to remove the risk of error in the final computation.
Ways to Improve Your Cash Conversion Cycle
Companies can concentrate on any of the three aspects that make up the CCC to enhance, meaning decrease, it.
Businesses can reduce CCC by increasing DPO, decreasing DSO, or decreasing DIO; these three changes have the same effect. Therefore, companies can optimize their cash conversion cycle and steer clear of frequent cash flow challenges in one of the various ways, including the following:
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Accelerate the process of turning inventory into sales.
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Quicker money collection from clients should be prioritized.
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Prolong the period it takes to pay off suppliers.
It is essential to understand that a firm’s cash conversion cycle does not exist in a vacuum because it reflects how it interacts with its consumers and suppliers.
Therefore, if a company decides to take a more extended period to pay its suppliers, those suppliers will experience a negative impact on their cash conversion cycle due to an increase in their DSO. Certain suppliers are experiencing difficulties with their cash flow, which could hamper their capacity to fulfill orders on schedule.
As a result, purchasing organizations may improve their supply chains by utilizing early payment schemes such as supply chain finance. Suppliers can obtain early payment on their invoices from a third-party funder, even though the firm will pay the invoice later.
If businesses implement a solution of this type, the buyer and the supplier can enhance their working capital conditions.
Cash Conversion Cycle in Accounting Defined and Explained – Conclusion
To increase a company’s cash flow, taking the required actions to reduce the length of the cash conversion cycle is helpful. Calculating CCC can assist you in better managing your inventory, credit sales, and buy management tactics.
It also gives you the ability to monitor your liquidity. Investors can use data from CCC to compare and contrast the cash flow management practices of other companies operating within the same industry.
By automating the procedures involved in creating client credit limits, maintaining inventory, and collecting payments, you may reduce the manual labor and errors required and the time it takes to collect payments.
Cash Conversion Cycle in Accounting Defined and Explained – Further Readings
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Updated: 12/10/2023
