The cash conversion cycle (CCC) is a metric that expresses the time (measured in days) it takes for a company to convert its investments in inventory and other resources into cash flows from sales. Also called the Net Operating Cycle or simply Cash Cycle, CCC attempts to measure how long each net input dollar is tied up in the production and sales process before it gets converted into cash received.
This metric takes into account how much time the company needs to sell its inventory, how much time it takes to collect receivables, and how much time it has to pay its bills without incurring penalties.
CCC?is one of several quantitative measures that helps evaluate the efficiency of a company& operations and management. A trend of decreasing or steady CCC values over multiple periods is a good sign, while rising ones should lead to more investigation and analysis based on other factors. One should bear in mind that CCC applies only to select sectors dependent on inventory management and related operations.
The Formula for CCC
Since CCC involves calculating the net aggregate time involved across the above three stages of the cash conversion lifecycle, the mathematical formula for CCC is represented as:
Cash Conversion Cycle Formula.Investopedia
DIO is days of inventory outstanding (also known as days sales of inventory (DSI));DSO is days sales outstanding; andDPO is days payables outstanding.
DIO and DSO are associated with the company’s cash inflows, while DPO is linked to cash outflow. Hence, DPO is the only negative figure in the calculation. Another way to look at the formula construction is that DIO and DSO are linked to inventory and accounts receivable, respectively, which are considered as short-term assets and are taken as positive. DPO is linked to accounts payable, which is a liability, and thus taken as negative.
A company’s cash conversion cycle broadly moves through three distinct stages. To calculate CCC, you need several items from the?financial statements:
Revenue and?cost of goods sold?(COGS) from the?income statement;Inventory at the beginning and end of the time period;Account receivable (AR) at the beginning and end of the time period;Accounts payable (AP) at the beginning and end of the time period; andThe number of days in the period (e.g. year & 365 days, quarter & 90).
The first stage focuses on the existing inventory level and represents how long it will take for the business to sell its inventory. This figure is calculated by using the Days Inventory Outstanding (DIO). A lower value of DIO is preferred, as it indicates that the company is making sales rapidly, and implying better turnover for the business.
DIO, also known as DSI, is calculated based on cost of goods sold?(COGS), which represents the cost of acquiring or manufacturing the products that a company sells during a period. Mathematically,?
where,?Average Inventory & (Beginning Inventory & Ending Inventory)/2
The second stage focuses on the current sales and represents how long it takes to collect the cash generated from the sales. This figure is calculated by using the Days Sales Outstanding (DSO), which divides average accounts receivable by revenue per day. A lower value is preferred for DSO, which indicates that the company is able to collect capital in a short time, un turn enhancing its cash position.
where,?Average Accounts Receivable & (Beginning AR & Ending AR)/2
The third stage focuses on the current outstanding payable for the business. It takes into account the amount of money the company owes its current suppliers for the inventory and goods it purchased, and represents the time span in which the company must pay off those obligations. This figure is calculated by using the Days Payables Outstanding (DPO), which considers accounts payable. A higher DPO value is preferred. By maximizing this number, the company holds onto cash longer, increasing its investment potential.
where,?Average Accounts Payable & (Beginning AP & Ending AP)/2
All the above mentioned figures are available as standard items in the financial 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 taken as 365 for a year and 90 for a quarter.
1:47 The Cash Conversion Cycle What Does the Cash Conversion Cycle Tell You?
Boosting sales of inventory for profit is the primary way for a business to make more earnings. But how does one sell more stuff? If cash is easily available at regular intervals, one can churn out more sales for profits, as frequent availability of capital leads to more products to make and sell. A company can acquire inventory on credit, which results in?accounts payable (AP). A company can also sell products on credit, which results in?accounts receivable?(AR). Therefore, cash isn& a factor until the company pays the accounts payable and collects the accounts receivable. Thus timing is an important aspect of cash management.
CCC traces the lifecycle of cash used for a business activity. It follows the cash as it& first converted into?inventory?and?accounts payable, then into expenses for product or service development, through to sales and?accounts receivable, and then back into cash in hand. Essentially, CCC represents how fast a company can convert?the invested cash?from start (investment) to end (returns). The lower the CCC, the better.
Inventory management, sales realization and payables are the three key ingredients of a business. If any of these goes for a toss – say, inventory mismanagement, sales constraints, or payables increasing in number, value, or frequency – the business is set to suffer. Beyond the monetary value involved, CCC accounts for the time involved in these processes that provides another view of the company’s operating efficiency. In addition to other financial measures, the CCC value indicates how efficiently a company’s management is using the short-term assets and?liabilities?to generate and redeploy the cash, and gives a peek into the company’s financial health with respect to the cash management. The figure also helps assess the?liquidity risk?linked to a company’s operations.
If a business has hit all the right notes and is efficiently serving the needs of the market and its customers, it will have a lower CCC value.
CCC may not provide meaningful inferences as a stand-alone number for a given period. Analysts use it to track a business over multiple time periods and to compare the company to its competitors. Tracking a company’s CCC over multiple quarters will show if it is improving, maintaining, or worsening its operational efficiency. While comparing competing businesses, investors may look at a combination of factors to select the best fit. If two companies have similar values for return on equity?(ROE) and?return on assets?(ROA), it may be worth investing in the company that has a lower CCC value. It indicates that the company is able to generate similar returns more quickly.
CCC is also used internally by the company’s management to adjust their methods of credit purchase payments or cash collections from debtors.
Key Takeaways The cash conversion cycle (CCC) is a metric that expresses the length of time (in days) that it takes for a company to convert its investments in inventory and other resources into cash flows from sales.This metric takes into account the time needed to sell its inventory, the time required to collect receivables, and the time the company is allowed to pay its bills without incurring any penalties.CCC will differ by industry sector based on the nature of business operations. CCC Applies to Select Sectors
CCC has a selective application to different industrial sectors based on the nature of business operations. The measure has a great significance for retailers like Walmart Inc. (WMT), Target Corp. (TGT), and Costco?Wholesale Corp. (COST), which are involved in buying and managing inventories and selling them to customers. All such businesses may have a high positive value of CCC.
However, CCC does not apply to companies that don’t have needs for inventory management. Software companies that offer computer programs through licensing, for instance, can realize sales (and profits) without the need to manage stockpiles. Similarly, insurance or brokerage companies don’t buy items wholesale for retail, so CCC doesn& apply to them.
Businesses can have negative CCCs, like online retailers eBay Inc. (EBAY) and Amazon.com Inc. (AMZN). Often, online retailers receive funds in their account for sales of goods that actually 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 onto the cash for a longer period of time, so they often end up with a negative CCC. Additionally, if the goods are directly supplied by the third-party seller to the customer, the online retailer never holds any inventory in-house.
A Harvard Business blogpost attributes the negative CCC as a key factor in Amazon& survival of the dot-com bubble of 2000. Operating with a negative CCC became a source of cash for the company, instead of being a cost for it.