Cash Conversion Cycle Formula
The cash conversion cycle can be described by the following equation:
Cash Conversion Cycle = DIO + DSO – DPO
Each of these variables can be thought of as a separate stage in the overall process that can be broken down further into the following elements.
DIO = Days Inventory Outstanding
DIO is the average number of days that a company holds onto inventory before selling it. The company would not benefit from producing parts and then holding on to them for a long period of time without sales. Instead, their goal should be to create inflow by selling the goods as quickly as possible and turning them into earnings.
The formula for DIO is:
DIO = ( Average Inventory / Cost of Goods Sold ) x 365
For example, suppose a company had a beginning and ending inventory of $5,000 and $10,000 respectively for the fiscal year. They also had $100,000 in cost of goods sold during this same time. In this situation, the DIO would be:
DIO = [ ($5,000 + $10,000) / 2 / $100,000 ] x 365 = 27.375 days
Note that some companies may have multiple products and customers. Since it would make the calculation too complicated to try to include each one, this is why an average is used.
DSO = Days Sales Outstanding
DSO is the average number of days it takes for a company to collect payment after a sale. While sales may be good for a company, they cannot pay their bills until cash has been received. Hence, the lower the time until payment, the better the inflow of revenue.
The formula for DSO is:
DSO = ( Average Accounts Receivable / Total Credit Sales ) x 365
For example, suppose a company had a beginning and ending accounts receivable of $12,000 and $20,000 respectively for the fiscal year. They also had $250,000 in credit sales during this same time. In this situation, the DSO would be:
DSO = [ ($12,000 + $20,000) / 2 / $250,000 ] x 365 = 23.36 days
Again, an average may be used to avoid making the calculation too complicated for those companies with multiple products and customers.
DPO = Days Payable Outstanding
DPO is the average number of days it takes for a company to pay the invoices it receives from its creditors. This is the outflow of money from the company that it owes to suppliers, vendors, etc.
The formula for DPO is:
DIO = ( Average Accounts Payable / Cost of Goods Sold ) x 365
For example, suppose a company had beginning and ending accounts payable of $6,000 and $8,000 respectively for the fiscal year. They also had $100,000 in cost of goods sold during this same time. In this situation, the DPO would be:
DIO = [ ($6,000 + $8000) / 2 / $100,000 ] x 365 = 25.55 days
Again, an average may be used to avoid making the calculation too complicated for those companies with multiple suppliers and COGS.
Calculating the Cash Conversion Cycle
Using each of the elements above, we can now determine that its cash conversion cycle would be:
CCC = 27.375 + 23.36 - 25.55 = 25.185
In other words, it takes the company just over 25 days to turn an investment in inventory back into cash flow.
What Does the Cash Conversion Cycle Mean?
The main use of the cash conversion cycle is for a company to understand how long it will take before an inventory investment becomes cash. For instance, the company may wish to increase production output or add another product line. However, before they can do this, they'll need to know long before they see a return on that investment. Companies can only pay bills with cash, not anticipated earnings. Therefore, they’ll need to know exactly how long it will take before this investment can be translated into tangible revenue.
You can generally think of shorter CCCs as being better than longer CCCs. For example, company managers would prefer to get their money back in 30 days as opposed to 60 days.
While there are technically no "good" or "bad" values for CCC, it can be helpful to compare the CCC of companies within the same industry to get an understanding of how well they manage their working capital. In fact, some companies may even have negative CCC indicating that it's already receiving payments before it has to pay their bills.
Additionally, higher CCC might reveal that one of the three stages in the process has an issue. For instance, a high CCC might be traced back to a higher-than-normal DSO. The root cause may be that the buyer is having trouble making payments to the company.
How to Reduce the Cash Conversion Cycle
There are several ways that a company can improve its CCC and become more efficient. This mainly involves optimizing one or more of the three stages involved with the CCC.
For example, the company could:
- Streamline inventory management (i.e., reduce DIO). This may be done by utilizing JIT or “just in time” suppliers who can deliver parts immediately when needed.
- Increase marketing to sell the goods it has on hand faster (i.e., reduce DIO). This may be accomplished by launching an aggressive advertising or social media campaign.
- Reduce the time it gives customers to pay their invoices (i.e., reduce DSO). This could be done by having more stringent payment terms (for instance, 30 days instead of 45), following up on late payments, or posing penalties for late payments.
- Request increased payment terms from its suppliers (i.e., increase DPO). This may be done by negotiating better credit terms with the company’s largest vendors.
Again, recall that companies often have multiple products, customers, and suppliers. While making improvements to these stages may seem relatively straightforward, the reality is that they can be somewhat complex depending on the size and structure of the company.
The Bottom Line
The cash conversion cycle or CCC quantifies how efficiently a company turns its inventory into cash flow. By reducing the amount of inventory on hand, improving payment speed from customers, and taking longer to pay suppliers, a company can improve its CCC. While there is not necessarily a "good" value for CCC, its generally perceived that the lower the number of days the better.
Because of the complexities of having various product lines, multiple customers, and supply chains, averages are used to calculate the cash conversion cycle. CCC can be used as a means of comparing customers within the same industry to investigate how well they manage their processes.