What is the cash conversion cycle and how can you calculate it?

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The cash conversion cycle (CCC) is a key indicator of how efficiently a business manages its working capital and cash flow. It measures how long it takes for a company to convert its inventory into sales and then collect the cash from customers, minus the time it pays its suppliers. The shorter the CCC, the better, as it means the business can free up more cash for other purposes, such as investing, paying dividends, or reducing debt. In this article, you will learn how to calculate the CCC and how to use it to compare the performance of different businesses or industries.

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Felipe Maia Linhares

FMVA? | Senior FP&A Analyst at Neoenergia

1 Components of CCC

The CCC, composed of days inventory outstanding (DIO), days sales outstanding (DSO), and days payable outstanding (DPO), is an average number of days that a business holds or owes a certain type of asset or liability. To calculate the CCC, you need to be aware of information from the income statement and balance sheet such as cost of goods sold (COGS), sales revenue, inventory, accounts receivable, and accounts payable. These items represent the total cost of producing or acquiring goods or services, the total amount of money earned from selling them, the value of goods or materials ready for sale or in the process of being sold, and the amount of money customers owe or that the business owes its suppliers for goods or materials they have purchased on credit.

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Felipe Maia Linhares

FMVA? | Senior FP&A Analyst at Neoenergia
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I like to think about this as a relation of investing and funding: Our Supplier may give us a 30 day term of payment in a good - that's our third part funding for money in a sense - if we use 25 days to sell the same good and 15 days to receive from our customer at the end we're investing 40 days and the difference between the funding and the investment must be paid. Time is money, when we are funded by a supplier it means that, in a short period of time, will be the supplier who, in a way, is paying the bills. However if our customer payment term is bigger than our supplier-fundind we'll have to pay the bills of our supplier before even receive - so we'll need an extra amount of cash.

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2 Calculating DIO, DSO, and DPO

To calculate the DIO, you need to divide the inventory by the COGS and multiply by 365. This gives you the average number of days that the inventory stays in the business before it is sold. For example, if a business has an inventory of $10,000 and a COGS of $20,000, its DIO is:

DIO = ($10,000 / $20,000) x 365 = 182.5 days

To calculate the DSO, you need to divide the accounts receivable by the sales revenue and multiply by 365. This gives you the average number of days that the customers take to pay the business for their purchases. For example, if a business has an accounts receivable of $5,000 and a sales revenue of $25,000, its DSO is:

DSO = ($5,000 / $25,000) x 365 = 73 days

To calculate the DPO, you need to divide the accounts payable by the COGS and multiply by 365. This gives you the average number of days that the business takes to pay its suppliers for their purchases. For example, if a business has an accounts payable of $15,000 and a COGS of $20,000, its DPO is:

DPO = ($15,000 / $20,000) x 365 = 273.75 days

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3 Calculating CCC

To calculate the CCC, you need to subtract the DPO from the sum of the DIO and the DSO. This gives you the net number of days that the business needs to convert its inventory into cash, after paying its suppliers. For example, if a business has a DIO of 182.5 days, a DSO of 73 days, and a DPO of 273.75 days, its CCC is:

CCC = (182.5 + 73) - 273.75 = -18.25 days

This means that the business can generate cash from its inventory 18.25 days faster than it pays its suppliers, which is a positive sign of efficiency and liquidity.

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4 Interpreting CCC

The CCC can vary widely depending on the nature and size of the business, the industry, and the market conditions. Generally, a lower CCC is preferable, as it indicates that the business can quickly turn its inventory into cash and reduce its need for external financing. However, a negative CCC is not always better than a positive one, as it may also imply that the business is selling its inventory too cheaply, extending too much credit to its customers, or delaying its payments to its suppliers, which can affect its profitability and reputation. Therefore, it is important to compare the CCC of a business with its historical trends, its competitors, and its industry averages, to get a more accurate picture of its performance and potential.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Felipe Maia Linhares

FMVA? | Senior FP&A Analyst at Neoenergia
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I would add some extra points: - This is an average number and it can change. Recalculate past some time. Exclude the outliers. Monitor. Normalize the data [...] at the end it's an idea of the real Working Capital and the real CCC of the company but it grant you great insights. - Study also risk notions for cash (Cash at Risk) - Give a look on the incredible Fleuriet's model and see how Working Capital is only a part of a bigger puzzle - Remeber, Working Capital is one of the main reasons why small and medium sized companies close doors. Do not underestimate it.

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What is the cash conversion cycle and how can you calculate it?

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1 Components of CCC

2 Calculating DIO, DSO, and DPO

3 Calculating CCC

4 Interpreting CCC

5 Here’s what else to consider

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