Cash conversion cycle

A metric that expresses the length of time, in days, a company takes in order to convert resource inputs into actual cash flows. It attempts to measure the amount of time each net input dollar is tied up in the production and sales process before it is converted into cash through sale to customers. This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties. Also known as "cash cycle".

Calculated as:


Where:
DIO represents days inventory outstanding
DSO represents days sales outstanding
DPO represents days payable outstanding

Investopedia Says:
Usually a company acquires inventory on credit, which results in accounts payable. A company can also sell products on credit, which results in accounts receivable. Cash, therefore, is not involved until the company pays the accounts payable and collects accounts receivable. So the cash conversion cycle measures the time between outlay of cash and cash recovery.

This cycle is extremely important for retailers and similar businesses. This measure illustrates how quickly a company can convert its products into cash through sales. The shorter the cycle, the less time capital is tied up in the business process, and thus the better for the company's bottom line.

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Elapsed time, usually expressed in days, from the outlay of cash for raw materials to the receipt of cash after the finished goods have been sold. Because a profit is built into the sales, the term earnings cycle is also used. The shorter the cycle, the more Working Capital a business generates and the less it has to borrow. This cycle is directly affected by production efficiency, credit policy, and other controllable factors.

The cash conversion cycle (CCC) is a key measurement of small business liquidity. The cycle is in essence the length of time between cash payment for purchase of resalable goods and the collections of accounts receivable from the sale of such goods to customers; as such, it focuses on the length of time that funds are tied up in the cycle. Large business firms tend to have shorter CCC periods than do small retail businesses. The latter institutions, however, can take steps to reduce the length of their cash conversion cycles, including reducing inventories or receivables conversions. CCC length is also inversely related to organizational cash flows, and a significant positive relationship exists between CCCs and current and quick ratios.

Effective management of the cash conversion cycle is imperative for small business owners. Indeed, it is cited by economists and business consultants as one of the truest measurements of business health available to entrepreneurs, especially during periods of growth. "Some of the traditional tools designed to provide a measure of overall guidance can become unstable at high rates of growth," explained John Costa in Outlook. "Others are more dangerous still; they provide the wrong signal at crucial points of working capital buildup. For example, the current and quick ratios are popular with companies and their bankers. In a period when collections have slowed, asset turns have become sluggish and vendors have not extended terms beyond previously agreed limits, the current ratio would probably look good." At the same time, the quick ratio may even show improvement or remain steady, even though the company is actually in substantial need of working capital. This happens, suggested Costa, because of the balance-sheet-oriented limitations of current and quick ratios. "These quick and dirty ratios fall short of what a rapidly changing, dynamic company needs," he stated flatly.

Instead of the above, potentially misleading measurements, small business owners should consider using cash conversion cycles, which, according to Costa usually provide a more accurate reading of working capital pressure on cash flows. "The objective is to keep your CCC as low as possible," he explained. "At a minimum, you should strive to maintain a constant CCC during periods of rapid sales growth. Unless inventory, credit, or vendor policies change, rapid growth should not cause the CCC to increase.…Because the CCC is related to asset turnover, it is more dynamic and therefore more accurate. What's more, it is easy to calculate" and explain to key staffers.

Cash conversion cycles for small businesses are predicated on four central factors: 1) the number of days it takes customers to pay what they owe; 2) the number of days it takes the business to make its product (or complete its service); 3) the number of days the product (or service) sits in inventory before it is sold; 4) the length of time that the small business has to pay its vendors. Inc. provided the following formulas to determine these factors:

• Small businesses can figure their accounts receivable days by dividing their receivables balance by their last 12 months' sales, then multiplying the result by 365 (the number of days in a year).
• Inventory days, meanwhile, can be determined by taking inventory balance, dividing by the last 12 months' cost of goods sold, and then multiplying the result by 365.
• Accounts payable days can be figured by taking the company's payables balance, dividing it by the last 12 months' cost of goods sold, and then multiplying the resulting figure by 365.

Once a small business owner has these figures in hand, he/she can figure out the company's cash conversion cycle by adding the receivable days to the production and inventory days, then subtracting the payables days. "That will tell you the number of days your cash is tied up and is the first step in calculating how much money you'll want in your revolving line of credit," Inc. concludes.

Further Reading:

Costa, John. "Challenging Growth: How to Keep Your Company's Rapid Expansion on Track." Outlook. September 1997.

Hilton, Ronald W. Managerial Accounting. New York: McGraw-Hill, 1991.

Moss, Jimmy D., and Bert Stine. "Cash Conversion Cycle and Firm Size: A Study of Retail Firms." Managerial Finance. December 1993.

"The Numbers You'll Need." Inc. August 1999.

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