What is a Cash Conversion Cycle and What Can You Learn From It?

People in the stock market tend to feel that complicated things are the most effective, but simple things have been found to be a superior choice in both personal life and the stock market. Cash Conversion Cycle is an example of a comparable concept.

 

It is a basic yet effective method of determining the efficiency of a company's operations.

 

What is a Company’s Cash Conversion Cycle?

 

The cash conversion cycle is a cash flow calculation that seeks to determine how long it takes a business to convert its inventory and other resource inputs into cash. To put it another way, the cash conversion cycle calculation determines how long cash is held in inventory until it is sold and paid to customers.

 

The cash cycle is divided into three phases. The current inventory level and how long it will take the company to sell this inventory are represented in the first portion of the cycle. The day's inventory outstanding calculation is used to calculate this stage.

 

The current sales and the time it takes to collect the cash from these sales are represented in the second stage of the cash cycle. The day's sales outstanding calculation is used to compute this.

 

The current overdue payables are represented in the third stage. In other words, this shows how much a firm owes its current vendors for inventory and product purchases, as well as when the company must pay them back. The days payable outstanding calculation is used to determine this.

 

Also Read | Cash Flow Management

 

Let’s take a look at the three parts separately:

 

1. DIO (Days Inventory Outstanding)

 

It is a measure of how long an item has been on the shelf. This is the average time it takes to turn inventory into finished goods, which are subsequently sold. DIO is calculated by multiplying your average inventory by the cost of goods sold and multiplying by 365.

 

2. DSO (Days Sales Outstanding)

 

This is the average number of days it takes to collect your accounts receivable. DSO is calculated by calculating your accounts receivable by net credit sales and multiplying by 365.

 

3. Days Payable Outstanding (DPO)

 

This is the average time it takes for your company to buy from vendors and then pay them (accounts payable). DPO is calculated by dividing the ending accounts payable by (cost of goods sold 365).

 

The Formula for the Cash Conversion Cycle is as follows:

 

CCC = Days inventory outstanding + Days sales outstanding - Days Payables Outstanding

 

The days of inventory outstanding are the most amenable to major modification of all the variables of the cycle. The statistics for receivables are rather consistent, however the payment conditions for payables are determined by existing contracts with suppliers. As a result, a wise management team will concentrate its efforts on reducing inventory investment.

 

What constitutes a Good Cash Conversion Cycle?

 

A short cash conversion period is ideal. If your CCC is low or (better still) negative, your working capital is not locked up for long periods of time, and your company has more liquidity. 

 

Many online businesses have low or negative CCCs because they drop-ship instead of retaining inventory, receive immediate payment when customers buy things, and do not have to pay for inventory until customers have already paid them.

 

You don't want your CCC to be too high if it's a positive number. A positive CCC indicates how many days your company's working capital is stranded as it waits for accounts receivable to be paid. If you sell things on credit and your customers require 30, 60, or even 90 days to pay you, you may have a high CCC.

 

You may shorten your company's cash conversion cycle in a number of ways. Make your accounts receivable procedure as efficient as possible, for starters. Remove any needless jargon from your bills and be explicit about what you're billing for and the terms you're requesting. You'll get paid faster if the buyer understands the invoice quickly. 

 

You can also reduce the CCC by requesting advance payments or offering a discount for paying early. Finally, staying on top of late payments by following up as soon as a payment is due is a good idea.

 

Also Read | Invoice Processing

 

Importance of the Cash Conversion Cycle

 

The average number of days it takes for a corporation to convert initial investment into cash returns is tracked by its cash conversion cycle. This enables a business to determine how efficient its operations are and which parts of the process are the least effective at generating cash flow.

 

A low CCC indicates that a company's inventory chain is working smoothly, whereas a high figure can suggest financial or inventory management problems. Understanding CCC can assist a company pinpoint where cash flow is being hampered, whether it's due to inventory mismanagement, excessive payables, or sales issues.

 

 

 

Variables involved in Cash Conversion Cycle

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Variables involved in Cash Conversion Cycle

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A number of operational and accounting variables are taken into account while calculating the cash conversion cycle. A company's financial documents, such as a balance sheet or an income statement, contain several of these variables. Here are the five factors to consider when estimating a company's cash conversion cycle.

 

1. Sales and COGS (Cost of Goods Sold)

 

The CCC is calculated using revenue from the sale of goods and the cost of producing those things, both of which may be seen on a company's income statement.

 

2. Receivables

 

The sum is payable to the company to cover the cost of products and inventory sold at the start and conclusion of the CCC period. This is reflected by the average DSO (days sales outstanding) for the time period, which indicates how quickly a company collects outstanding debtor payments.

 

3. Accounts Payable

 

The amount of money owed by a company to retailers or suppliers for goods produced at the start and end of the CCC period. DPO (or days payable outstanding) is a ratio that approximates the number of days it takes a corporation to pay off things in its accounts payable period.

 

4. Inventory

 

When calculating the cash conversion cycle, you'll need to know how much inventory you have at the start and end of the CCC period. This is usually expressed as DIO (days inventory outstanding), which is a metric that measures how rapidly a company offloads its inventory.

 

5. Time

 

Take into account the number of days in the period in which you're calculating your CCC.

 

Can Cash Conversion Cycles be Negative?

 

Cash conversion cycles can be either positive or negative, depending on when a business decides to clear its account payables. If the bills due are settled prior to collecting the receivables, the cash conversion cycle remains positive. However, if a company decides to postpone its liabilities to its suppliers until after acquiring the receivables, this would result in negative cash conversion cycles.

 

Although a positive conversion cycle is preferable, businesses can also function just as well with

negative cycles. The feasibility depends largely on the circumstances and scope of the business. 

 

For instance, smaller businesses may find it difficult to delay payment to suppliers until the collection of receivables. On the other hand, for example companies like Amazon can operate with negative cash cycles, since their suppliers are more than happy to accommodate such requests.

 

 

What Role does Cash Flow Play?

 

The cash conversion cycle is a cash flow formula that determines how long it takes for your company to convert inventories and other assets into cash. To put it another way, the cash-to-cash cycle time is the time between when you pay for inventory and when customers pay to replenish your business's cash flow. 

 

Keeping cash flow positive in industries with high inventory and material demands, such as construction, can be the difference between taking on new clients and turning them away.

 

The conversion cycle calculation determines how long a company's cash is held until it is recovered from clients and customers. Keeping a careful eye on the company's CCC might help you keep track of its total finances as money comes in and goes out. 

 

If you're confused about the differences between cash flow and profit, keep in mind that they're not the same thing. While profit is the amount of money left over after a company's expenses have been paid at a certain moment in time, cash flow is flexible. It shows how much money is coming in and going out of a company.

 

What Can You Learn From the Cash Conversion Cycle?

 

The primary strategy for a company to increase profits is to increase inventory sales. But how can one increase sales? If cash is readily available at regular intervals, one can churn out more sales for profit, as more things to create and sell result from the frequent availability of money. Inventory can be purchased on credit, resulting in accounts payable (AP).

 

A business can also sell things on credit, resulting in accounts receivables (AR). As a result, cash isn't a consideration until the company pays its bills and collects its receivables. As a result, cash management relies heavily on timing.

 

The lifespan of cash utilized for corporate activities is tracked by CCC. It tracks cash as it moves from cash in hand to inventory and accounts payable, then to product or service development expenses, sales and accounts receivable, and finally back to cash in hand. 

 

CCC is a measure of how quickly a corporation can convert invested cash from start (investment) to finish (exit) (returns). The CCC should be as low as possible.

 

How might the Cash Conversion Cycle be Improved?

 

Companies can focus on any of the three components of the CCC to enhance (lower) it. Increasing DPO, lowering DSO, and lowering DIO all lower the CCC. Companies can enhance their cash conversion cycle and avoid common cash flow issues in a number of ways:

 

1. Increase the amount of time it takes to pay suppliers.

 

2. Obtain money from customers as quickly as possible.

 

3. Increase the rate at which inventory is converted into sales.

 

It's vital to remember, however, that a company's cash conversion cycle doesn't exist in a vacuum; it explains how a company interacts with its suppliers and consumers. 

 

As a result, if a company waits longer to pay its suppliers, those suppliers will experience a negative impact on their own cash conversion cycle due to an increase in DSO. Suppliers may encounter cash flow constraints in some situations, which could jeopardize their ability to fulfill orders on schedule.

 

As a result, purchasing businesses may decide to use early payment schemes like supply chain finance to improve their supply chains. Suppliers can obtain early payment from a third-party funder on their bills, while the company pays the invoice at a later date. Both the buyer and the supplier can benefit from this type of solution to improve their working capital conditions.

 

Also Read | Cash Flow Analysis

 

Watch this | What is The Cash Conversion Cycle - CCC?

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The cash conversion cycle is a critical indicator for determining how efficiently a company can turn its inventory into sales and then into cash. The CCC formula is used to determine how well a business manages its working capital. 

 

The shorter the cash conversion cycle, like with other cash flow computations, the better the organization is at selling inventories and recovering cash while paying suppliers. A business likes to see a lower value of this cycle because it promotes healthy working capital levels, cash flows, liquidity, and profitability.