What is Cash Conversion Cycle?
The Cash Conversion Cycle is an estimate of the approximate number of days it takes a company to convert its inventory into cash after a sale to a customer.
Table of Contents
- How to Calculate Cash Conversion Cycle?
- Cash Conversion Cycle Formula
- Cash Conversion Cycle Calculator
- 1. Working Capital Assumptions
- 2. Cash Conversion Cycle Calculation Example
- 3. Cash Conversion Cycle Analysis Example
- How to Improve Cash Conversion Cycle?
- What is a Good Cash Conversion Cycle?
- What Causes a Negative Cash Conversion Cycle?
- How to Analyze Cash Conversion Cycle?
How to Calculate Cash Conversion Cycle?
The cash conversion cycle measures the time required for the company to clear out its stored inventory, turn its outstanding accounts receivables (A/R) balance into cash, and how long the payment date to suppliers for goods/services received can be pushed out.
By consistently monitoring the cash conversion cycle (CCC) metric, the company can identify and improve operational deficiencies related to working capital that reduce free cash flows (FCFs) and liquidity.
The “cycle” refers to the process companies undergo in purchasing inventory, selling the inventory to customers on credit (i.e., accounts receivable), and collecting cash payments from these customers.
The calculation of the cash conversion cycle (CCC) is composed of three working capital metrics:
The following chart summarizes the main points regarding the three working capital metrics.
|Working Capital Metric
|Days Inventory Outstanding (DIO)
|Days Sales Outstanding (DSO)
|Days Payable Outstanding (DPO)
Cash Conversion Cycle Formula
The formula for calculating the cash conversion cycle sums up the days inventory outstanding and days sales outstanding, and then subtracts the days payable outstanding.
- Operating Cycle → The first portion of the formula, “DIO + DSO”, is called the operating cycle, which is the number of days for inventory to be converted into finished goods and then sold, plus the average number of days receivables (A/R) remain outstanding on the balance sheet before cash collection.
- Subtract Days Payable Outstanding (DPO): To finish the calculation, the average duration the company takes to pay off its outstanding accounts payable (A/P) balance is deducted from the operating cycle.
Hence, the CCC is used interchangeably with the term “net” operating cycle. Given that a lower CCC is preferred, it should be intuitive to explain why DIO and DSO are added (increase in CCC = negative FCF impact), while DPO is subtracted (decrease in CCC = positive FCF impact).
Putting together the above, the CCC is equal to the average time needed for inventory to be sold and cash collected from customers – minus the timing “gap” between receiving products or services from suppliers/vendors and the date of actual payment.
Cash Conversion Cycle Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. Working Capital Assumptions
Suppose we’re tasked with calculating the cash conversion cycle (CCC) of a company using the following working capital assumptions:
- Days Inventory Outstanding (DIO) → 85 Days in 2017; Decreasing by 1 Day Per Year
- Days Sales Outstanding (DSO) → 40 Days in 2017; Decreasing by 2 Days Per Year
- Days Payables Outstanding (DPO) → 60 Days in 2017; Increasing by 2 Days Per Year
2. Cash Conversion Cycle Calculation Example
Given those assumptions, we can tell the company has been gradually improving in all three categories.
Upon extending the 2017 hard-coded assumptions and step function into the rest of the years, we can calculate the historical CCC for 2018 to 2020.
The completed output sheet illustrates the downward trajectory in the cash conversion cycle (CCC) from 65 days in 2017 to 50 days by 2020.
3. Cash Conversion Cycle Analysis Example
The year-over-year progress in the company’s cash conversion cycle (CCC) demonstrates that management identified areas in the business model that require improvement and effectively implemented the necessary adjustments to produce tangible results.
How to Improve Cash Conversion Cycle?
The NWC changes on the left side each have positive implications on free cash flow (FCF).
In comparison, the right side shows the opposing change and contrasting impact on FCFs.
The target number of days for the CCC differs substantially by the industry the company operates within and the nature of products/services sold (e.g., purchase frequency, order volume, seasonality, cyclicality).
However, the lower the CCC, the more beneficial it is for the company, as it implies less time is needed to convert working capital into cash on hand.
In addition, it is particularly useful to track the CCC metric for a particular company year-over-year (YoY) – and to benchmark against comparable peers in the same industry.
What is a Good Cash Conversion Cycle?
As a generalization, companies with lower CCCs tend to be better off from a cash management perspective.
If CCC is trending downward relative to previous periods, that would be a positive sign, whereas CCC trending upward points towards potential inefficiencies in the business model.
- High Cash Conversion Cycle → A higher cash conversion cycle means the real cash flow profile of the company deviates further from how it is portrayed on the income statement.
- Low Cash Conversion Cycle → Low CCCs are often a byproduct of clearing out inventory quickly, possessing bargaining power over suppliers, and having payment collection processes in place that are effective at retrieving cash from customers who paid on credit.
CCCs that are high relative to the industry benchmark indicate that a larger proportion of the company’s cash is tied up in its operations. For instance, the company might hold inventory in its storage facilities for an extensive duration before those items are sold.
- Positive Cash Conversion Cycle → A positive cash conversion cycle, even if on the lower end relative to comparable companies, is still a “use” of cash at the end of the day.
- Negative Cash Conversion Cycle → While uncommon, certain companies can have negative CCCs, which means the net impact is a “source” of cash. A negative CCC would be accomplished by frequently turning over inventory and receiving cash payments for products sold before paying suppliers.
What Causes a Negative Cash Conversion Cycle?
One of the most frequently cited examples of companies with a negative cash conversion cycle (CCC) is Amazon (AMZN).
By having a negative CCC, Amazon could essentially finance its operations through its favorable delayed payment terms with suppliers due to the time lag. However, unlike traditional debt financing, this came with no interest.
For an unprofitable company with steep losses, this freely available cash helped fund Amazon’s growth initiatives and played an influential role in shaping the company into what it is today.
Even compared to other market leaders, such as Walmart, which are known for their efficiency, Amazon had a significantly lower CCC that dipped below zero.
Amazon Cash Conversion Cycle (Source: HBR.org)
How to Analyze Cash Conversion Cycle?
The reason why cash conversion cycle (CCC) is such an important metric is that it can be used to evaluate the operating efficiency of a particular company, as well as the decision-making capabilities of the management team.
One of the main reasons that net income falls short in capturing the actual liquidity of the company is due to working capital – most notably inventory, accounts receivable (A/R) and accounts payable (A/P).
- Inventory → In the best-case scenario, the amount of inventory purchased and type of products sold should be met with adequate demand from the market (i.e., there is no build-up of inventory that the company is experiencing difficulty selling the product).
- Accounts Receivable → For A/R, customers who previously paid using credit rather than cash pay off their outstanding balance sooner. Despite the revenue being recognized (i.e., “earned”) on the income statement under accrual accounting standards, the cash has yet to change hands, since the customers are delaying their payments
- Accounts Payable → A/P increasing on the balance sheet suggests the company has “buyer power” (i.e., bargaining leverage when it comes to negotiating supplier terms), which enables them to delay payments – as the seller awaits the payment from the buyer, the buyer is then free to use that cash for various other purposes