Cash Conversion Cycle

Introduction

The Cash Conversion Cycle (CCC) is a financial metric used to measure the time it takes for a business to convert its investments in inventory and other resources into cash. It represents the number of days between when a company pays for its inventory and when it receives payment from its customers.
A company's CCC can be positive or negative. A negative CCC means that a company is able to generate cash from its operations before it has to pay its suppliers, while a positive CCC means that a company has to pay for its inventory before it receives payment from its customers.
By monitoring their CCC, businesses can identify inefficiencies in their operations and take steps to improve their cash flow management. A shorter CCC indicates a faster cash conversion, which can lead to better liquidity and financial stability.
 

How do you calculate Cash Conversion Cycle? (Step by step)

You can calculate the Cash Conversion Cycle (CCC) using the following steps:

Step 1: Determine the Days Inventory Outstanding (DIO)
DIO measures the average number of days it takes for a company to sell its inventory. To calculate DIO, divide the average inventory by the cost of goods sold per day. The formula for DIO is

DIO = (Average Inventory / Cost of Goods Sold per day)

Step 2: Determine the Days Sales Outstanding (DSO)
DSO measures the average number of days it takes for a company to collect payment from its customers. To calculate DSO, divide the accounts receivable by the total credit sales per day. The formula for DSO is
DSO = (Accounts Receivable / Average Credit Sales per day)

Step 3: Determine the Days Payable Outstanding (DPO)
DPO measures the average number of days it takes for a company to pay its suppliers. To calculate DPO, divide the accounts payable by the cost of goods sold per day. The formula for DPO is:
DPO = (Accounts Payable / Cost of Goods Sold per day)

Step 4: Calculate the Cash Conversion Cycle (CCC)
The CCC is calculated by subtracting the DPO from the sum of DIO and DSO. The formula for CCC is:
CCC = DIO + DSO - DPO

A positive CCC means that the company pays for its inventory before receiving payment from its customers, while a negative CCC means that the company receives payment from its customers before paying for its inventory.
 

How to interpret Cash Conversion Cycle? (High vs. Low)

Interpreting the Cash Conversion Cycle (CCC) depends on whether it is high or low. A high CCC indicates that a company is taking a long time to convert its investments in inventory and other resources into cash, while a low CCC indicates that a company is able to convert its investments into cash more quickly. Here's what a high or low CCC could mean for a company:

High CCC

●    It shows that a company is taking a long time to convert its investments in inventory and other resources into cash. 
●    This can be an indication of poor liquidity and inefficient cash flow management.
●    It may result in cash shortages and difficulty paying bills, leading to financial distress. 
●    This may indicate that the company is carrying too much inventory or is offering customers long payment terms.

Low CCC 

●    Indicates that a company is able to convert its investments in inventory and other resources into cash quickly. 
●    This means that the company generates cash from its operations before it has to pay its suppliers. 
●    This is a positive sign of efficient cash flow management and strong liquidity. 
●    This may result in better profitability and financial stability.

Benchmarking 

●    The ideal CCC may vary by industry and business model. 
●    Some businesses, such as retailers and manufacturers, typically have a higher CCC due to the nature of their operations, while service-oriented businesses may have a lower CCC. 
●    It's important to benchmark your CCC against your industry peers to determine if your company's CCC is within an acceptable range.
 

Cash Conversion cycle formula

The Cash Conversion Cycle formula for calculating the CCC is as follows:

CCC = DIO + DSO - DPO
Where,
DIO: Days Inventory Outstanding, which is the average number of days it takes for a company to sell its inventory.
DSO: Days Sales Outstanding, which is the average number of days it takes for a company to collect payment from its customers.
DPO: Days Payable Outstanding, which is the average number of days it takes for a company to pay its suppliers.
 

Cash Conversion Cycle Calculation Example

Let's say Company ABC has the following financial information: 

●    Average inventory = Rs 50,000 
●    Cost of goods sold (COGS) = Rs 200,000 
●    Accounts receivable = Rs 30,000 
●    Total credit sales = Rs 150,000 
●    Accounts payable = Rs 20,000
To calculate the CCC, we need to calculate the Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO), and Days Payable Outstanding (DPO) using the formulas mentioned earlier:

DIO = (Average Inventory / Cost of Goods Sold per day)

= (Rs 50,000 / (Rs 200,000 / 365)) = 91.25 days 

DSO = (Accounts Receivable / Total Credit Sales per day)

= (Rs 30,000 / (Rs 150,000 / 365)) = 73 days \

DPO = (Accounts Payable / Cost of Goods Sold per day)

= (Rs 20,000 / (Rs 200,000 / 365)) = 36.5 days 

Now we can use these values to calculate the CCC: 

CCC = DIO + DSO - DPO = 91.25 days + 73 days - 36.5 days = 127.75 days 

So, Company ABC's CCC is 127.75 days, which means it takes them 127.75 days on average to convert their investments in inventory and other resources into cash. This value can be compared to industry benchmarks to determine if Company ABC is performing well in terms of cash conversion efficiency. If the CCC is too high, it may indicate that the company is not managing its cash flow efficiently and may face liquidity issues.
 

Conclusion

In conclusion, the Cash Conversion Cycle (CCC) is an important financial metric that gives us an overview of the company’s financial health and cash flow. A lower CCC indicates faster cash conversion and better liquidity, while a higher CCC indicates slower cash conversion and potentially poor liquidity. The ideal CCC may vary by industry and business model, so it's important to benchmark your company's CCC against industry peers to determine if it's within an acceptable range.