Cash conversion cycle
The cash conversion cycle (CCC) is a critical metric that businesses use to evaluate their financial performance. Understanding the cash conversion cycle is essential for managing cash flow effectively and optimising a company's financial operations. In this blog, we will explore the concept of the cash conversion cycle and how it can be used to analyse a company's financial health.
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Pages in this SectionKey takeaways
- The cash conversion cycle (CCC) is a metric that measures the amount of time it takes for a company to convert its inventory and other resources into cash flow.
- The CCC is calculated by adding the number of days it takes for a company to sell its inventory, the number of days it takes for a company to collect its accounts receivable, and the number of days it takes for a company to pay its accounts payable.
- A negative CCC indicates that a company is able to convert its resources into cash flow more quickly than it takes to pay its suppliers, which can be a sign of good financial health.
- A positive CCC indicates that a company takes longer to convert its resources into cash flow than it takes to pay its suppliers, which can be a sign of financial risk.
- The CCC can be used to identify inefficiencies in a company's financial operations and to optimise cash flow management.
Understanding the cash conversion cycle
The cash conversion cycle (CCC) is a financial metric that measures the amount of time it takes for a company to convert its inventory and other resources into cash flow.
The cash conversion cycle is an important indicator of a company's ability to manage its cash flow effectively, and is calculated by adding the number of days it takes for a company to sell its inventory, the number of days it takes for a company to collect its accounts receivable, and the number of days it takes for a company to pay its accounts payable.
Calculating the cash conversion cycle
What are the 3 components of the cash conversion cycle?
Days inventory outstanding (DIO)
The number of days it takes for a company to sell its inventory. This metric is calculated by dividing the cost of goods sold by the average inventory level and multiplying the result by 365.
Days sales outstanding (DSO)
The number of days it takes for a company to collect its accounts receivable. This metric is calculated by dividing the average accounts receivable by the average daily sales and multiplying the result by 365.
Days payable outstanding (DPO)
The number of days it takes for a company to pay its accounts payable. This metric is calculated by dividing the average accounts payable by the average daily purchases and multiplying the result by 365.
What is the formula for the cash conversion cycle?
Once you have the 3 components of the cash conversion cycle, you can calculate the CCC using the following formula:
CCC = DIO + DSO - DPO
The result will either be positive or negative...
A negative cash conversion cycle
- A negative cash conversion cycle indicates that a company is able to convert its resources into cash flow more quickly than it takes to pay its suppliers, which can be a sign of good financial health.
- A company with a negative cash conversion cycle can use the excess cash to invest in growth opportunities or pay down debt.
A positive cash conversion cycle
- A positive cash conversion cycle indicates that a company takes longer to convert its resources into cash flow than it takes to pay its suppliers, which can be a sign of financial risk.
- A company with a positive cash conversion cycle may need to secure additional financing to support its operations.
Example of how to use the cash conversion cycle
Let's take a hypothetical example of a company that sells widgets. The company has an inventory turnover ratio of 5, an accounts receivable turnover ratio of 6, and an accounts payable turnover ratio of 4.
We can use these ratios to calculate the company's CCC:
- DIO = 365 / 5 = 73 days
- DSO = 365 / 6 = 61 days
- DPO = 365 / 4 = 91 days
- CCC = 73 + 61 - 91 = 43 days
This means that it takes the company 43 days to convert its inventory and accounts receivable into cash flow, after taking into account the time it takes to pay its suppliers.
If the company's CCC is higher than its industry average, it may indicate that the company is not managing its cash flow effectively and may need to make changes to its operations.
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