 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 (DPO)
60 days DIO + 45 DSO - 40 DPO = 65 Days
In this example, FreshFabric has a 65-day cash conversion cycle. It means it needs 65 days of working capital to purchase inventory and convert it to cash.
Courtesy: Canva/ 74images
What Does a Negative Cash Conversion Cycle Mean?
A negative or steady cash conversion cycle suggests that the company has a high inventory turnover rate and sells its inventory prior to paying for Stock Keeping Unit.
SKU is a unique identifier assigned typically by a manufacturer or a retailer to track inventory and is usually associated with a barcode.
On the other hand, a positive cash conversion cycle indicates that the company’s working capital is constrained until the accounts receivable are paid.
As with any improvement initiative in your company, you wouldn’t know where to begin unless you know where you stand currently.
The first step to improving your CCC should always be calculating the average time it takes for your company to recoup your investment.
You may have the opportunity to improve your business’s cash flow if it’s anywhere longer than 30 days.
7 Tips to Improve Cash Conversion Cycle
1. Closely Monitor Working Capital Metrics
To improve your cash conversion cycle, it’s important to closely monitor and adjust your working capital metrics: DIO, DSO, and DPO.
To adjust the DIO, for instance, developing good working relations with your suppliers helps because it helps manage just-in-time (JIT) and eventually reduces inventory shelf life. JIT inventory management is when you receive only the exact amount of inventory you need right when you need it.
For DSO, offering early paying discounts encourages your clients to pay their invoices early. Other good strategies are to shorten the accounts receivable terms, such as from 30 days to 15 days, and to improve the collection process.
These strategies speed up the time it takes to collect payments. However, find a balance in the collection process in such a way that it will not negatively affect your relations with your clients.
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