The cash conversion cycle is one of many different metrics that businesses and investors use to determine the operational efficiency and potential value of a company. Find out how this metric is calculated and why it matters.
Cash Conversion Cycle Definition
The cash conversion cycle (CCC), also known as the Net Operating Cycle or Cash Cycle, measures the time it takes for a businesses' investments to be translated into sales and revenue. This metric accounts for the time it takes to move inventory, get paid, and pay debts without incurring additional fees or interest. CCC is typically measured in days.
CCC is one of the ways businesses and stakeholders can objectively measure the quality and effectiveness of a business' operations and management. Because increasing efficiency and reducing production costs is always desirable for increasing profit margins, most businesses try to steadily decrease or maintain their CCC over time.
However, not all businesses use this metric. CCC is most useful for industries that lean on physical inventories. Retail businesses are a common example of a type of company that would derive a lot of meaning from the CCC metric.
Cash Conversion Cycle Formula
Calculating CCC comes down to one formula:
CCC = DIO + DSO - DPO
It's not as simple as it looks. Let's break down the components of this formula into greater depth.
- CCC (Cash Conversion Cycle)
- DIO (Days of Inventory Outstanding): The average number of days needed to clear the inventory.
- DSO (Days of Sales Outstanding): The average number of days needed to collect payment after a sale.
- DPO (Days Payables Outstanding): The average number of days it takes a company to pay its bills.
In order to find the numbers needed to use the CCC formula, you need pull multiple data points from the business' financial statements, including:
- The set number of days or time period you are measuring
- Total revenue and cost of goods sold within a given time
- The total inventory in the beginning and end of a given time
- How many receivables the company has at the beginning and end of a given time
- How much the company owes at the beginning and end of a given time
All of these items are typically found on a standard financial statement.
How to Calculate Cash Conversion Cycle
To better understand how CCC is calculated, let's use an example as our guide. The metrics below are measured in millions of dollars.
Say a company wants to calculate their CCC for the fiscal year 2018 and compare it to their numbers for the fiscal year 2017. They would first begin by gathering the numbers needed to plug into the formula. Say these are the numbers gathered from their financial statements:
Fiscal Year 2017
Fiscal Year 2018
Cost of Goods Sold
To get the DIO, DSO, and DPO for the CCC formula, you must first determine the following:
- Average inventory: (3,000+2,000)/2= $2,500
- Average accounts receivable: (200+100)/2 =$150
- Average accounts payable: (500+600)/2 =$550
This is how they would calculate each component of the CCC formula using the numbers above:
- DIO: Average inventory/cost of goods sold per day
- DSO: Average accounts receivable/revenue per day
- DPO: Average payables/cost of goods sold per day
In our example, the components above would look something like this:
- DIO: $2,500 / ($5,000/365 days) = 182.5 days
- DSO: $150 / (10,000/365 days) = 5.5 days
- DPO: $550 / (5,000/365 days) = 40 days
You would then follow the formula above to calculate the CCC: 182.5 + 5.5 - 40 = 148 days
In order to utilize the CCC metric properly, the company would need to track the CCC over time to see its progression and leverage the number for comparison against competitors in the same market.
How to Interpret Cash Conversion Cycle
Moving inventory faster and more efficiently while also buttoning up receivables and bill payments are essential for making profits. This is easy to understand. However, the CCC metric offers an opportunity to track the available capital that a company has to use toward growth and other priorities. Having a lower CCC can be an indicator of future growth and efficient operations.
For investors, tracking CCC over multiple quarters can give them insight into the current and future health of the business. This number, when considered alongside other factors, can also help investors choose between two competing companies that they are considering for investment.
For the business, knowing their CCC is essential for not only determining the monetary value and potential but also identifying possible choke points in the production or sales process for a product or service. Rising CCCs indicate production and management challenges that need to be addressed, while a steady or declining CCC points to increased operational efficiencies.
While the metric should never be considered in isolation, CCC can be a helpful tool for better understanding a business from both an internal and external perspective.
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