There are many financial measures a small business owner must keep an eye on in order to run a profitable business. While you’re probably on top of measures such as cash flow and sales projections, you may not be as diligent in monitoring your cash conversion cycle. Here’s a closer look at what the cash conversion cycle is, how to calculate it, and why it matters to you and to any potential financing sources you may approach.
What is the Cash Conversion Cycle?
Sometimes called the net operating cycle or cash cycle, the cash conversion cycle (CCC) measures how long it takes your business to convert cash into inventory, then into sales, and finally back into cash again. You arrive at the CCC by figuring out how long it takes you to sell inventory, how long it takes you to collect on accounts receivable, and how soon you have to pay your accounts payable.
The cash conversion cycle can be expressed as a formula:
CCC = days inventory outstanding (DIO) + days sales outstanding (DSO) – days payables outstanding (DPO)
The shorter your company’s cash conversion cycle is, the better. If your CCC is a low or (better yet) negative number, that means your working capital isn’t tied up for long, and your business has greater liquidity. Many online retailers have low or even negative CCC’s because they drop ship instead of maintain inventory, get paid right away when customers buy products, and don’t have to pay for the inventory until customers have already paid them.
If your CCC is a positive number, you don’t want it to be too high. A positive CCC reflects how many days your business’s working capital is tied up while you’re waiting for your accounts receivable to be paid. You may have a high CCC if you sell products on credit and have customers that typically take 30, 60 or even 90 days to pay you.
Why the Cash Conversion Cycle Matters
There are several reasons it’s important to monitor your cash conversion cycle:
- Investors, lenders and other financing sources will often assess a company’s cash conversion cycle in order to determine its financial health and, in particular, its liquidity. The more liquid a company is, the more easily it can pay back a business loan, meet its other financial obligations and invest in growth. The cash conversion cycle is most useful as a way to assess inventory-based businesses, such as retailers. It isn’t the only financial yardstick that financing sources use; they will generally combine it with other measures before making a decision.
- Suppliers sometimes factor in your CCC when deciding whether or not to extend you credit. If your business lacks adequate liquidity, they may worry that you won’t be able to pay them on time.
- The cash conversion cycle matters to you, as well. A low CCC indicates you’re doing well at converting inventory to cash, and shows that your business is operating efficiently. On the other hand, if your CCC is too high, it might be a sign of operational issues, a lack of demand for your product, or a declining market niche. If your CCC isn’t to your liking, figure out what the problem is and take steps to correct it, such as being more aggressive in collecting on invoices.
- Finally, your cash conversion cycle is an important measure to take when you’re figuring out how much money you need to borrow. Understanding your CCC and, as a result, your business’s liquidity will help you calculate how much cash you should ask a lender for.
Does your cash conversion cycle fail to measure up to what lenders are looking for? There are still ways to get the money you need. Consider alternative financing sources, such as invoice-based financing from Fundbox.