Efficient cash flow management is a cornerstone of business success, and the cash conversion cycle plays a pivotal role in it. This key metric sheds light on the efficiency of a company’s cash flow operations and offers valuable insights into its liquidity management by quantifying the time taken to convert investments into cash.
What is the cash conversion cycle (CCC) with example?
The cash conversion cycle, also known as the cash flow cycle, is a measure of the time taken to convert a company’s investments in inventory into cash. In other words, a cash cycle starts when a firm purchases inventory and ends when it receives cash payments from its sales. It is expressed in terms of the number of days.
The cash flow cycle diagram is as follows:
It is an important metric for companies with significant physical inventory holdings. Firms with shorter cash conversion cycles have better operational efficiencies and financial health.
So, what is an example of a cash flow cycle?
Assume a hypothetical company, XCV Ltd., purchases raw materials with payments due in 30 days to suppliers. These materials are then transformed into finished goods and sold in 15 days. Also, the customers make the payments within 45 days.
In this scenario, the cash flow cycle begins with the purchase of raw materials and ends with cash collection. It means the company, on average, takes 30 days (15+45-30) to convert its inventory investment into cash.
How do you calculate cash flow cycle?
A cash flow cycle, or a cash conversion cycle, represents three core business activities: the sale of inventory, the cash collection from sales to customers, and vendor payments. These elements of the cash cycle are measured by days inventory outstanding (DIO), days sales outstanding (DSO), and days payables outstanding (DPO), respectively.
DIO measures the number of days it takes the company to sell its inventory. DSO quantifies the number of days it takes to collect payments from customers. DPO measures the average time taken by the company to pay its invoices to its suppliers or trade creditors.
The cash conversion cycle formula is as follows:
Cash conversion cycle (CCC) = Days inventory outstanding (DIO) + Days sales outstanding (DSO) - Days payables outstanding (DPO)
Here,
DIO = Average inventory / Cost of goods sold x 365
DSO = Average accounts receivable / Net credit sales x 365
DPO = Average accounts payable / Cost of goods sold x 365
Let us understand the calculation of the cash flow cycle with an example.
A company AXC Ltd. reports the following numbers for FY20xx.
| Opening Balance (£) | Closing Balance (£) | Average Balance (£) | |
|---|---|---|---|
| Inventory | 2,000 | 6,000 | (2,000 + 6,000) / 2 = 4,000 |
| Accounts Receivable | 8,000 | 12,000 | (8,000 + 12,000) / 2 = 10,000 |
| Accounts Payable | 2,000 | 4,000 | (2,000 + 4,000) / 2 = 3,000 |
Assuming AXC Ltd. records cost of goods sold (COGS) worth £100,000 and net credit sales of £200,000, the cash conversion cycle will be calculated as follows:
DIO = 4,000 / 100,000 x 365 = 14.6
DSO = 10,000 / 200,000 x 365 = 18.25
DPO = 3,000 / 100,000 x 365 = 10.95
CCC = 14.6 + 18.25 – 10.95 = 21.90
It means it takes AXC Ltd. approximately 21 days to convert its inventory investment into cash.
What is a good cash conversion cycle?
Generally, a shorter cash conversion cycle indicates optimised and efficient working capital management. Ideally, a cash cycle averages between 30 to 45 days. However, these cycles can vary significantly between industries.
Benchmarking a firm’s CCC against its peers or industry competition is a better indicator of its financial health. This is because some industries, such as supermarkets, may lack receivables, while others may function without inventories, like service providers, resulting in vastly different cash cycles.
Moreover, it is more valuable to analyse the trends in a company’s CCC. For instance, if the firm’s cash conversion cycle increases over time, it signals a deterioration in working capital management.
Firms can shorten their cash conversion cycles by reducing their inventory or by collecting customer payments quickly. Delaying supplier payments is another method to improve CCC.
Can the cash conversion cycle be negative?
The cash conversion cycle can be negative if a company enjoys a strong market position, which enables it to dictate its terms to its suppliers and customers.
A negative cash conversion cycle indicates that the company is receiving payments on accounts receivable sooner than it is paying its suppliers. Online retailers tend to experience negative CCC.
What does a high CCC mean?
A high cash conversion cycle signals that the companies take a long time to generate cash from their inventory investments. Small businesses with longer CCCs share a higher risk of turning insolvent. Higher CCCs can be a consequence of selling products to buyers on credit terms extending beyond 60-90 days.
Conversely, a low cash conversion cycle indicates quick cash generation, enabling organisations to pare down their debt, make additional asset purchases, and maintain a healthy financial position.
Typically, firms must vie for a low or negative CCC cycle, as it indicates that they are not incurring unduly high holding costs with their working capital tied up in inventory. To illustrate, online retailers have low CCCs because they tend to maintain low inventory levels, with many drop-shipping them, and are paid right away when their clients make a purchase.
How to improve the cash conversion cycle?
Improving cash conversion cycles mostly involves tweaking the working capital metrics underlying them, including DIO, DSO, and DPO. Below, we list some strategies to shorten your cash cycles.
👉 Better payables management: The majority of organisations begin their cash cycle shortening process by extending average days payable. By leveraging supplier relationships and negotiating better terms, companies can delay their cash outflows for a certain period of time.
For instance, if a vendor offers 30-day payment terms without the option of an early payment discount, then companies must wait out the payment period and put that money to additional use. However, due care must be taken not to overstrain these relationships, as this can lead to cash flow issues for suppliers.
👉 Optimise inventory management: Speeding up average days’ inventory is another strategy to improve your cash flow cycles. Slow inventory turnover ratios require companies to aggressively clear out their stock. This can be done by monitoring your product lines and income statement data to distinguish between bestsellers and duds.
Steps can also be taken to improve customer relationships, which will further improve procurement and sales forecasts. While reducing inventory holding is desirable, it should not come at the cost of poor customer service, with the firm unable to process orders, resulting in poor sales.
👉 Reassess receivables management: By taking advantage of automation tools, companies can ensure that they timely issue accurate invoices to their customers, making their collection processes more efficient. Streamlining payment options is one way to reduce average days receivable. This can be supplemented by offering early payment discounts and by separating any collection charges from the direct cost of goods sold to avoid scenarios where clients dispute payments.
Also, consider categorising your customers based on their payment habits, risk profile, and size, and following up with slow payers. Efforts must be made to analyse the reasons for payment delays so that a collection process can be designed accordingly. Aggressive cash collection methods should be avoided in order to not permanently damage client relationships.
Ultimately, pursuing lean business models and incrementally reviewing collection and payment terms with vendors and customers, respectively, is essential to shorten your cash conversion cycle. Organisations must also take a hard look at their entire cash cycle to eliminate any redundant steps by automating their data collection and cash flow processes.
What is the importance of the cash conversion cycle?
A firm’s cash flow cycle is significant for the following reasons:
Analyse business performance: Companies can evaluate their performance by evaluating their CCC’s yearly trends and comparing it with their peers. Longer cash cycles may be indicative of operational issues such as inventory build-up or poor payment collection.
Negotiate better terms with suppliers: Companies with short cash flow cycles are extended goods on credit at better terms. Firms with strong market positions may even negotiate for longer payment terms, resulting in negative cash cycles.
Avail of better loans: A healthy cash flow cycle shows that the company runs its business efficiently and has successfully streamlined its cash flows. It indicates to the lenders that the business can easily service its loans, enabling access to affordable credit, which further fuels growth investments.
Evaluate liquidity position: CCC measures the firm’s ability to maintain liquid assets. Positive cash flows are important to ensure that a business meets all its operating expenses, including payroll, inventory purchases, rent, and more. It also improves upon the firm’s cash flow forecasting capabilities.
What is a good example of a cash conversion cycle?
Generally, a shorter cash conversion cycle indicates optimised and efficient working capital management. Ideally, a cash cycle averages between 30 to 45 days. However, these cycles can vary significantly between industries.
Benchmarking a firm’s CCC against its peers or industry competition is a better indicator of its financial health. This is because some industries, such as supermarkets, may lack receivables, while others may function without inventories, like service providers, resulting in vastly different cash cycles.
Moreover, it is more valuable to analyse the trends in a company’s CCC. For instance, if the firm’s cash conversion cycle increases over time, it signals a deterioration in working capital management.
Firms can shorten their cash conversion cycles by reducing their inventory or by collecting customer payments quickly. Delaying supplier payments is another method to improve CCC.
Key takeaways
- The cash conversion cycle is an important financial metric which reveals how efficient a business is at managing its cash flows by measuring the time taken to convert investments in inventory back into cash.
- Firms with shorter CCCs relative to their peers signal an optimised liquidity position and working capital management.
- Good CCC management enables better cash flow forecasting and supports stronger balance sheet ratios, resulting in increased creditworthiness and improved loan sourcing.
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