Cash Conversion Cycle Formula: How to Calculate & Improve

The cash conversion cycle (CCC) can help a company analyze its financial health. A manager can use this formula to learn more about the company’s accounts payable, accounts receivable, and inventory management.

This article will help you learn how to calculate or analyze this formula. It will also cover how to improve financial operations.

What is the Cash Conversion Cycle Formula?

The cash conversion cycle formula is a very useful formula that a company can use to analyze its financial health. The cash conversion cycle formula shows approximately how many days it takes for a company to convert its inventory to cash. This formula can determine how efficiently a company uses its working capital. A company that analyzes this formula on a quarter-to-quarter basis may find ways to improve its operations.

Most businesses may find it helpful to use the cash conversion cycle formula. However, this formula is most appropriate for businesses that have lots of physical inventory, such as retailers like Walmart or Target. On the other hand, this formula isn’t as useful for some service businesses, like insurance companies or some software companies.

How to Calculate the Cash Conversion Cycle

The formula for cash conversion cycle is easy to calculate if you already have important financial data such as your accounts receivable, inventory balance, and accounts payable.

What is the formula for cash conversion cycle?

You can use this formula to calculate the cash conversion cycle. This formula is based on a company’s inventory, accounts receivable, and accounts payable.

Cash Conversion Cycle = Days of Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding

1) Days Inventory Outstanding: The DIO shows how long it takes for a company to sell its inventory. You can use the following formula to calculate the Days inventory outstanding.

DIO= Average Inventory/COGS x 365 Days

In this case, the average inventory is calculated as the weighted average of the beginning inventory balance and the ending inventory balance.

Average inventory= 0.5 x (Beginning Inventory + Ending Inventory)

A lower DIO ratio shows that a company is selling its products very rapidly.

2) Days Sales Outstanding: After this, you need to calculate the DSO, which shows how many days it takes a company to collect cash from a sale.

DSO = Average Account Receivable / Revenue per day

The average account receivable balance is based on the weighted average of the beginning and ending AR balance.

Average account receivable= 0.5 x (Beginning AR balance + Ending AR Balance)

3) Days Payable Outstanding: The final part of this formula is the DPO, which shows how long it takes for the company to pay its bills to creditors and suppliers.

To calculate the DPO, you need to know your total accounts payable balance and your COGS. The formula is as follows:

DPO= Average account payable / Cost of goods sold per day

The average accounts payable is calculated based on a weighted average of the beginning and ending accounts payable balance.

Average accounts payable = 0.5 (Beginning AP + Ending AP)

If a company has a higher DPO, it means that it can hold onto its cash for a longer period.

Below is a cash conversion cycle formula example. The best way to start is to organize all of the information about your inventory, accounts receivable, and accounts payable. After this, you can begin to calculate the DIO, DPO, and DSO.

Example

Assume that this company has $40,000 in COGS and net credit sales of $250,000.

The cash conversion cycle could be calculated as follows:

DIO= ($2,500/$40,000) x 365 days = 22.8 days

DSO= ($30,000/$250,000) x 365 days = 43.8 days

DPO= ($4,000/$40,000) x 365 days = 36.5 days

CCC= 22.8 + 43.8 - 36.5
CCC= 29.8 days

In this example, it takes the company around 30 days to convert its inventory into cash. This industry could be relatively favorable if it is in an industry like manufacturing, which typically has a higher CCC.

Once you complete the formula for cash conversion cycle, you can use this formula to analyze strengths and weaknesses in your business. Many businesses track the CCC every quarter to take note of any trends. For example, a business may notice that it has issues with its accounts receivable, which could negatively impact its cash flow. In the example above, the company could lower its AR balance to potentially have a lower or even negative CCC.

There are plenty of free cash conversion cycle Excel templates that you can download online. This cash conversion cycle formula cfa cheat sheet can also be a helpful resource.

What Causes a Negative Cash Conversion Cycle?

Some companies may have a negative cash conversion cycle. Contrary to how it sounds, this is a very favorable metric. If a company has a negative cash conversion cycle, it can convert its inventory and resources into cash before it needs to pay its suppliers for the materials needed.

There are many ways that a company can achieve this measure. It can ensure that its customers always pay on time, and effectively manage its accounts receivables and delinquent payments. It may also use favorable inventory management processes, such as just-in-time inventory management, to lower holding costs.

Companies like this can use its working capital to finance its daily operations and may be able to use the additional funds to pay its debt or reinvest in other areas. These companies are also more likely to be profitable and to have a stronger cash balance.

How to Improve Your Cash Conversion Cycle

There are many steps that a company can take to improve its cash conversion cycle.

Manage Receivables: A company may need to work to change its payment collection systems. While generous terms may encourage sales, delayed payment terms may cause cash flow issues for companies. In some cases, it may be better to require customers to make payments over a shorter time.

Inventory management: Companies may also be able to use other inventory management strategies, such as just-in-time inventory management and economic order quality. Inventory management systems can help companies be more efficient and reduce holding costs.

Technology: A company may benefit from implementing new technologies and software that help improve its inventory management and other functions. Tools like accounting software, inventory management software, and invoicing systems can be helpful.

Invoice factoring: Invoice factoring is another popular strategy that can help improve your company’s cash flow. A company can choose to sell its invoices to a third-party company. These third-party companies buy the invoices at a discount in exchange for providing the company with immediate cash. For some smaller companies, it may make sense to use an invoice factoring company due to the benefit of improved liquidity.

Financial analysis: Taking a look at a CCC at one point in time isn’t very useful. Companies can analyze their CCC and cash flow every quarter, and note any new trends. A steady or declining CCC is generally a good sign, which shows that a company is improving its cash flow and operations.

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