The availability of cash is a significant factor influencing corporate performance. Without it, managing daily and long-term business becomes tough.
And one of the various measures of cash availability, cash flow, and management effectiveness is the cash conversion cycle.
In this guide, you’ll learn what CCC is and how to improve it to free up more cash to reduce your debt, pay your bills, and invest in your business. Let’s get started.
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What Is the Cash Conversion Cycle (CCC)?
The cash conversion cycle (CCC), also called the net operating cash cycle or simply the cash cycle, is the time it takes for a company to turn its inventory, investment, and other business resources into profit.
Importance of Cash Conversion Cycle in a Business
The CCC represents a significant metric to measure the company inventory’s operational efficiency. It’s also an important metric to determine that a company has sufficient cash flow.
It is usually used by stakeholders in assessing the company’s financial liquidity and health.
They would see that a lower CCC means that the company can quickly convert its receivables and inventory into cash, improving its ability to pay back business loans and meet financial obligations.
Many vendors also look at the company’s CCC before offering a trade credit. Typically, CCC is lower in companies that function efficiently or have sound cash flow management.
When accounts receivable departments are slow to secure payments, and businesses waste resources, there tends to have higher CCC.
Here’s how you calculate the CCC:
CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
To calculate your company’s CCC, you must first determine the period you need the calculation for. Is it for a quarter or a year, perhaps?
Accountants typically recommend about 13 weeks timeframe to calculate because most businesses already have enough cash flow data to make accurate calculations during such a period.
You’ll then need some information from your balance sheets and income statements, including the following:
Accounts receivable at the start and end of the period
Inventory at the start and end of the period
Revenue for the period
Accounts payable at the start and end of the period
Cost of goods sold or COGS for the period
Using the data above, you or your accountant can calculate the individual metrics to determine the cash conversion cycle.
Related Reading: Accounting Method Accrual vs. Cash: Understanding the Differences
Days Inventory Outstanding (DIO)
This is the average number of days the company takes to sell the entire inventory. The smaller the DIO is, which means you held the inventory for less time, the more efficient the company is in converting the working capital into inventory.
Days Sales Outstanding (DSO)
This is the number of days needed to collect payment from accounts receivable. The smaller the DSO is, the better it is for the business. In fact, reducing DSO accelerates cash flow into the company.
Businesses that implement immediate payment have zero DSo, while a business that has net 15 or net 30 payment terms will have a positive DSO number.
Days Payable Outstanding (DPO)
This is the average days it takes for a business to pay its bills. Usually, the longer you pay the bills, the shorter your cash conversion cycle is because you hold cash longer after the sale of inventory. The larger the DPO is, the better.
Cash Conversion Cycle Example
FreshFabric is a fabric store business with inventories that includes fabric, dyes, thread, and print designs. On average, FreshFabric purchases enough of these inventories to last for 60 days or the total number of days it takes to sell the entire inventory (DIO).
FreshFabric has a policy of paying its accounts payable to its suppliers within 40 days (DPO). On average, it also has steady customers who pay their invoices in 45 days (DSO). Here’s FreshFabric’s formula for the cash conversion cycle:
CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DP