Understanding the Cash Conversion Cycle

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There are many financial measures a small business owner needs to keep an eye on to run a profitable business. While you’re probably on top of metrics 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 a company’s cash conversion cycle?

Sometimes called the net operating cycle or cash cycle or cash-to-cash cycle time, 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 calculate the cash conversion cycle by figuring out how long it takes you to sell inventory, how long it takes you to collect your accounts receivable, and how soon you can pay your accounts payable.

The three components of the cash conversion cycle are:

  1. Days Inventory Outstanding (DIO). This is the average time to convert inventory into finished goods and then sell them. You can calculate DIO by taking your average inventory, dividing by the cost of goods sold, and then multiplying by 365.
  2. Days Sales Outstanding (DSO). This is the average number of days your accounts receivable takes to be collected. You can calculate DSO by taking your accounts receivable, dividing by net credit sales, and then multiplying by 365.
  3. Days Payable Outstanding (DPO). This is the average length of time it takes your business to purchase from vendors and then pay (accounts payable) them. You arrive at DPO by taking the ending accounts payable and dividing by (cost of goods sold ÷ 365).

The cash conversion cycle can be expressed as a formula:

CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)

What’s a good cash conversion cycle?

A good cash conversion cycle is a short one. If your CCC is a low or (better yet) a negative number, that means your working capital is not tied up for long, and your business has greater liquidity. Many online retailers have low or even negative CCCs because they drop-ship instead of maintaining inventory, get paid right away when customers buy products and do not have to pay for the inventory until customers have already paid them.

If your CCC is a positive number, you do not want it to be too high. A positive CCC reflects how many days your business’s working capital is tied up while you are waiting for your accounts receivable to be paid. You may have a high CCC if you sell products on credit and have customers who typically take 30, 60, or even 90 days to pay you.

There are several ways you can shorten your business’s cash conversion cycle. For one, make sure your accounts receivable process is as efficient as possible. Declutter your invoices of unnecessary jargon and be clear on what you’re invoicing for and the terms you’re asking. The quicker the customer understands the invoice, the faster you’ll get paid. You can also shorten the CCC by asking for upfront payments or offering a discount for early payment. Finally, it’s a good idea to stay on top of late payments by following up immediately when a payment comes due.

How cash flow fits in

The cash conversion cycle is a cash flow calculation that measures the period it takes your business to convert inventory and other resources into cash. In other words, the cash-to-cash cycle time is the amount of time between when you pay for inventory and the time it takes for customers to pay to replenish your business’s cash flow. For companies with heavy inventory and material demands, such as construction, keeping cash flow positive might make the difference between taking on new clients or turning them away.

The conversion cycle calculation helps a business determine how long their cash is tied up before it’s collected from clients and customers. Keeping a close watch on the business’s CCC helps monitor its overall finances as cash flows in and out. If you’re wondering about cash flow vs. profit, the two are not the same thing. While profit is the amount of money left after the business’s expenses have been paid at a specific point of time, cash flow is, well, fluid. It indicates the net flow of cash in and out of a business.

What’s the difference between operating cycle and cash conversion cycle?

The operating cycle is the number of days between when you buy inventory and when customers pay for the inventory. The cash conversion cycle is the number of days between when you pay for inventory and when you get paid by your customers for the inventory.

Why the cash conversion cycle matters

There are several reasons it is essential to monitor your cash conversion cycle:

  • Investors, lenders, and other financing sources often assess a company’s cash conversion cycle 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 beneficial to assess inventory-based businesses, such as retailers. It is not the only financial yardstick that financing sources use; they generally combine it with other measures before deciding whether to make the loan.
  • Suppliers sometimes factor in your CCC when deciding whether to extend your company credit. If your business lacks adequate liquidity, they may worry you won’t be able to pay them on time.
  • The cash conversion cycle matters to you, as well. A low CCC indicates you are doing well at converting inventory to cash and shows your business is operating efficiently. On the other hand, if your CCC is too high, it may 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 your invoices.
  • Finally, your cash conversion cycle is an important measure to take when you figure out how much money you need to borrow. Understanding your CCC and, as a result, your business’s liquidity can help you calculate how much cash you can 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.

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Tags: Financing