The cash-to-cash cycle is the time period between when a business pays a vendor for goods and when it receives payment for selling those goods. Its a financial method you can use to measure your businesss turn over and efficiency. By tracking the number of days it takes for your business to complete the lifespan of goods, you can understand where and when lags and bottlenecks happen.
Understanding RatiosEven though the cash-to-cash cycle is an important measurement on its own, it is actually the combination of three separate financial measurements.1. The time period it takes to pay for inventory is calculated as the days payables outstanding.2. The time period it takes to convert inventory into a sale is calculated as days inventory outstanding.3. The time period it takes to collect cash from a sale is calculated as the days sales outstanding. By adding these three calculations together, you can track your businesss entire cash-to-cash process.
Days Payables Outstanding (DPO)
The days payables outstanding is measured from the moment you receive inventory and have a legal obligation to pay for it. You calculate DPO by multiplying your average payables balance by the number of days in the period and dividing the result by the cost of your inventory. You get the average balance of accounts payable by taking the average between the beginning balance and ending balance for any period. This calculation shed light on your businesss ability to process payments. Its not indicative of cash flow problems, but if you have difficulty paying your bills on time, youll have a higher DPO calculation. You should strive to have a high DPO while remaining keeping up with your due dates. For example, if all vendors have payment terms of net 30, it is reasonable for a company to strive for a DPO of 25. This avoids late fees and maintains relationships with vendors. Paying your bills on time also maximizes your cash flow efficiency. A DPO calculation of 25 means that your company takes an average of 25 days to pay its bills.
Days Inventory Outstanding (DIO)
You calculate days inventory outstanding by dividing the average balance of your inventory by the cost of sales and multiplying the result by the number of days in the period. The average balance of inventory is the average between the beginning and ending inventory reported. Unlike the DPO, you should seek to minimize your DIO. The DIO represents the number of days on average inventory item sits in your stockroom waiting to be sold. During this period, your cash is tied to the asset, and it is not producing any income. So, you should take all measures to decrease your DPO. This can be done by doing marketing to raise awareness about your stock adjusting your prices.
Days Sales Outstanding (DSO)
The days sales outstanding is a measurement of the time it takes to receive payment once the inventory has been sold. This period starts once the inventory has been sold and ends when the cash payment has been received. Similar to the DIO, you can strive to minimize the number of days for this metric, because every day you hold onto an account receivable, you have less cash at your disposal to grow your business. And, a higher DSO is an indicator that customers are slower to pay and may result in uncollectible accounts. You calculate DSO by dividing the average accounts receivable balance by the total credit sales for a period and multiplying the result by the number of days in the period.
Usefulness of Cash-to-Cash Calculation
The cash-to-cash calculation can be useful in many ways. First, it can be translated into any period. For example, to find the cash-to-cash calculation for a specific quarter, 90 or 91 days can be used in each equation. To find the calculation for an entire year, 365 days may be used. In each case, you can target a specific time period which is important for seasonal businesses with fluctuating cash flows. The cash-to-cash cycle translates well across industries. By analyzing the cash-to-cash cycle of competitors, you can address your business’s weaknesses. For instance, if the industry average DSO is five days shorter than your calculation, you should consider whether you are issuing proper credit terms, extending too much credit, or not reviewing the creditworthiness of your customers enough. Also, the cycle can be compared across time frames to determine the progress of operational changes and if a company is improving. Ultimately, the cash-to-cash cycle provides insight to an entity’s entire operational process from the purchase of inventory to the sale of the final product.