What Is the Cash Conversion Cycle?
The cash conversion cycle is a metric that may be called different names, including cash cycle, cash-to-cash cycle, cash flow cycle, and cash realization model. It measures how many days a company takes to convert its inventory into sales. It gives investors a sense of how long each dollar that goes into the cost of goods sold is tied up in production and sales before it is converted into cash.
Cash Conversion Cycle Formula
The cash conversion cycle formula seeks the net aggregate time involved using the three stages of the cash conversion lifecycle.
The formula for the cash conversion cycle is:
CCC = DIO + DSO – DPO
DIO = Days of inventory outstanding
DSO = Days sales outstanding
DPO = Days payable outstanding
How To Calculate the CCC
To calculate the cash conversion cycle, you’ll need several data points from the company’s financial statements that include:
- Cost of goods sold
- Inventory beginning and end for the time period
- Accounts receivable at the start of the period
- Accounts payable at the end of the period
- Total number of days in the period (ie, 365 days for a year, 90 days for a quarter)
Tip: The income statement and balance sheet should provide investors with all the data they need to calculate the CCC.
These variables will be used to calculate the DIO, DSO, and DPO to then get the cash cycle.
1. Days Inventory Outstanding (DIO)
It takes money to buy or make the products sold by the company. The DIO defines how much it costs to do this for a specific period of time. It divides the average inventory by the cost of goods sold (COGS) and multiplies it by the period’s number of days.
To calculate it, you will use the following formula:
DIO = (Average Inventory / COGS) x 365 days
2. Days Sales Outstanding (DSO)
The DSO calculates how long it takes to collect money when sales are generated. Some companies get the cash immediately, while others may have a delay. The DSO divides the average accounts receivable by the revenue per day. To get the average accounts receivable, add the beginning inventory with the ending inventory and divide that by two.
The formula for DSO is:
DSO = Average Accounts Receivable / Revenue Per Day
3. Days Payable Outstanding (DPO)
To complete the needed calculation for the CCC, investors determine the DPO of the company, which is the accounts payable divided by the COGS per day. The DPO represents the time span that the company has to pay suppliers for the supplies and goods used to make its products.
The DPO formula is:
DPO = Average Accounts Payable / COGS Per Day
How Investors Use the Cash Flow Cycle
Investors use the CCC to determine how fast a company converts goods into cash, which is a strong indicator of its cash flow health. Ideally, investors want a fast conversion process, namely:
Investors seek a lower CCC as an indicator of a good process that doesn’t tie up money for extended periods of time.
Tip: Investors should look for companies with a low CCC, which means that they convert goods into cash quickly.
Negative Cash Conversion Cycle
It is possible to have a negative cash conversion cycle which means that the business is collecting money for inventory before paying for it. This is seen when companies presell a product to determine the interest in the product and fund the purchase of the inventory. Since a lower CCC is a good thing, a negative CCC is a positive indicator that a company is getting sales before outlaying cash.
Operating Cycle vs. Cash Cycle
The operating cycle is a more direct metric measuring the time it takes the company to convert inventory into cash. In contrast, the cash cycle considers the accounts receivable and that companies may not pay suppliers back immediately. The formula for the operating cycle is:
Operating Cycle = Inventory Period + Accounts Receivable Period
The operating cycle is a better indicator of a company’s operating efficiencies while the cash conversion cycle tells investors how well the company is managing money in and out of the business, namely its cash flow. The operating cycle tracks business progress over time, while a low CCC means that the company can access capital quicker for expansion.
Cash Cycle vs. Working Capital Cycle
Investors may hear another term along with cash cycle, which is the working capital cycle, The working capital cycle tells you the amount of capital needed to keep the company solvent, whereas the cash cycle is the time it takes to complete the purchase-to-sales process. Long working capital cycles mean a business has capital tied up for extended periods of time.
The formula for the working capital cycle is similar to the CCC:
Working Capital Cycle = Inventory Days + Receivable Days – Payable Days
The cash conversion cycle is an important metric that tells investors how fast a company converts manufacturing inventory into cash. Investors should look for companies with a short cycle which means it quickly turns inventory into revenues as part of a comprehensive evaluation of an investment.