Small wholesale or retail businesses require a delicate balance between inventory and cash flow. With too little inventory, you run the risk of not fulfilling customers’ needs, but if you have too much inventory, you might experience cash flow crunches. To avoid this situation, it helps to know how long you have to hold on to inventory investments before your get your money back. The cash conversion cycle calculation helps predict the amount of time it takes to convert your inventory investment to cash, which can improve the accuracy of your cash flow projections.
Cash Conversion Cycle Components
To calculate the cash conversion cycle, you need to know several figures with their own calculations. These include:
- Days inventory outstanding: Also called days sales of inventory, this calculation shows you how long it takes to turn your current inventory into sales. Though this amount varies across industries, the most successful businesses trend toward a smaller days inventory outstanding. To find your number, divide the cost of goods sold by 365, then divide the average inventory by your result.
- Days sales outstanding: The days sales outstanding calculation measures the average number of days it takes you to collect revenue from sales. You typically want a low days outstanding figure, which means it takes your company less time to collect its accounts receivable. On the flip side, a high value indicates it takes a long time to collect your sales revenue. To figure your days sales outstanding, divide your net credit sales minus any returns by 365, then divide your average accounts receivable by the result.
- Days payable outstanding: This calculation shows you how long it takes for you to pay bills and your accounts payable. A higher number means you hold onto cash for a longer amount of time, making higher numbers preferable. To find your days payable outstanding, divide the cost of goods sold by 365, then divide your average accounts payable by the result.
Once you have all those figures for your small business, you’re ready to calculate the cash conversion cycle. To do this, add the days inventory outstanding to the days sales outstanding, and then subtract the days payable outstanding.
Example Cash Conversion Cycle Calculation
Imagine a business has net sales of $75,000 for the fiscal year. During that time, customers return $5,000 in merchandise. The business purchases the goods it sells for $15,500, and it has an average inventory of $1,400, an average accounts receivable of $15,000, and an average accounts payable of $4,000. The calculation of each component of the cash conversion cycle is as follows:
- Days inventory outstanding: $1,400 / ($15,000 / 365) = 32.97
- Days of sales outstanding: $15,000 / (($75,000 – $5,000) / 365) = 78.21
- Days payable outstanding: $4,000 / ($15,500 / 365) = 94.19
Using the formula above, you figure the cash conversion cycle like: 32.97 + 78.21 – 94.19 = 16.99. This calculation means it takes the company about 17 days to pay for its inventory, sell it, and receive the cash from the sale. By knowing this approximate time table, the business can make more accurate cash flow projections.
Knowing how to calculate your business cash conversion cycle can help you get a better handle on your cash flow while keeping your warehouse or storage space well stocked. Also, by knowing how each component of the calculation works, you can better improve your business’s internal processes for optimal efficiency and profit. Improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.