What Is the Cash Conversion Cycle (CCC)?
The cash conversion cycle (CCC), also called the net operating cycle or cash cycle, considers how much time the company needs to sell its inventory, collect receivables, and pay its bills.
This metric expresses how many days the company takes to convert the cash spent on inventory back into cash from selling its product or service. The shorter the cash conversion cycle, the better, and the less time cash is in accounts receivable or inventory.
Key Takeaways
- The cash conversion cycle (CCC) is a metric that expresses the number of days it takes for a company to convert its inventory into cash flows from sales.
- The shorter the cash conversion cycle, the less time cash is in accounts receivable or inventory.
- CCC will vary by industry sector based on the nature of business operations.
Formula
CCC=DIO+DSO−DPOwhere:DIO=Daysofinventoryoutstanding(alsoknownasdayssalesofinventory)DSO=DayssalesoutstandingDPO=Dayspayablesoutstanding
DIO and DSO are associated with the company’s cash inflows, while DPO is linked to cash outflow. DPO is the only negative figure in the calculation. DIO and DSO are inventory and accounts receivable, respectively, considered short-term assets and "positive." DPO is linked to accounts payable, a liability regarded as "negative."
CCC represents how quickly a company can convertcashfrom investment to returns. The lower the CCC, the better.
Stages of the Cash Conversion Cycle
A company’s cash conversion cycle broadly moves through three distinct stages and draws the following information from a company'sfinancial statements. All figures are available as standard items in the statements filed by a publicly listed company as a part of its annual and quarterly reporting. The number of days in the corresponding period is 365 for a year and 90 for a quarter.
- Revenue andcost of goods sold(COGS) from theincome statement
- Inventory at the beginning and end of the period
- Accounts receivable (AR) at the beginning and end of the period
- Accounts payable (AP) at the beginning and end of the period
- The number of days in the period
Days Inventory Outstanding (DIO)
The first stage focuses on how long the business takes to sell its inventory. This figure is calculated by using the days inventory outstanding (DIO). A lower value of DIO indicates that the company is making sales rapidly with better turnover. DIO, also known as DSI (days sales of inventory), is calculated based on the cost of goods sold (COGS), or acquiring or manufacturing the products.
DIO (or DSI) = Average Inventory / COGS x 365 Days
Where:
Average Inventory = 0.5 x (BI + EI)
BI = Beginning Inventory
EI = Ending Inventory
Days Sales Outstanding (DSO)
The second stage focuses on how long the company takes the company to collect the cash generated from sales. This figure is calculated using the days sales outstanding (DSO), which divides average accounts receivable by revenue per day. A lower value indicates that the company can collect capital in a short time, enhancing its cash position.
DSO = Average Accounts Receivable / Revenue Per Day
Where:
Average Accounts Receivable = 0.5 x (BAR + EAR)
BAR = Beginning AR
EAR = Ending AR
Days Payable Outstanding (DPO)
The third stage includes the cash the company owes its current suppliers for the inventory and goods it purchases and the period in which it must pay off those obligations. This figure is calculated using the days payable outstanding (DPO), which considers accounts payable. A higher DPO value means the company holds onto cash longer, thus increasing its investment potential.
DPO = Average Accounts Payable / COGS Per Day
Where:
Average Accounts Payable = 0.5 x (BAP + EAP)
BAP = Beginning AP
EAP = Ending AP
COGS = Cost of Goods Sold
What the CCC Value Means
The cash conversion cycle evaluates the efficiency of a company’s operations and management. Tracking a company’s CCC over multiple quarters will show if it is improving, maintaining, or worsening its operational efficiency.
If cash is easily available at regular intervals, a company can churn out more sales for profits, as the availability of capital leads to more products to make and sell. A company that acquires inventory on credit results inaccounts payable (AP). A company can also sell products on credit, which results inaccounts receivable (AR).
Cash isn’t a factor until the company pays the accounts payable and collects the accounts receivable. Timing is an important aspect of cash management. CCC traces the life cycle of cash used for business activity. It follows cash through inventory and accounts payable, then into expenses for product or service development, to sales andaccounts receivable, and then back into cash in hand.
Examples
CCC has a selective application to different industrial sectors based on the nature of business operations. The measure affects retailers like Walmart Inc. (WMT), Target Corp. (TGT), and CostcoWholesale Corp. (COST), which are involved in buying and managing inventories and selling them to customers.
However, CCC does not apply to companies that don’t need inventory management. Software companies that offer computer programs through licensing, for instance, can realize sales without the need to manage stock. Similarly, insurance or brokerage companies don’t buy items wholesale for retail, so CCC doesn’t apply to them.
Businesses like retailer Amazon.com Inc. (AMZN) can have negative cash conversion cycles. Often, online retailers receive funds in their accounts for goods that belong to and are served by third-party sellers who use the online platform. However, these companies don’t pay the sellers immediately after the sale but may follow a monthly or threshold-based payment cycle. This mechanism allows these companies to hold the cash longer, so they may have a negative CCC.
What Affects the Cash Conversion Cycle?
Inventory management, sales realization, and payables are the three metrics that affect the CCC. Beyond the monetary value involved, CCC accounts for the time involved in these processes and provides another view of the company’s operating efficiency.
How Does the Cash Conversion Cycle Relate to Liquidity?
The CCC value indicates how efficiently a company’s management uses short-term assets andliabilitiesto generate and redeploy the cash and gives a peek into the company’s financial health concerning cash management. The figure helps assess theliquidity risklinked to a company’s operations.
How Does Inventory Turnover Affect the Cash Conversion Cycle?
A higher, or quicker, inventory turnover decreases the cash conversion cycle. Thus, a better inventory turnover is a positive for the CCC and a company’s overall efficiency.
The Bottom Line
When a company takes too long to collect outstanding accounts receivable, has too much inventory, or pays its expenses too quickly, it lengthens the CCC. A longer CCC means it takes longer to generate cash. When a company collects payments quickly, correctly forecasts inventory needs, or pays its bills slowly, it shortens the CCC. A shorter CCC means that the company is healthier. If two companies have similar values for return on equity (ROE) andreturn on assets (ROA), investors may choose the company with the lowest CCC value. It indicates that the company can generate similar returns more quickly.
