2018-06-11 02:52:45Finance and AccountingEnglishLearn what a cash conversion cycle is and why it's important to your business. Understand how to calculate your company's cash conversion...https://quickbooks.intuit.com/in/resources/in_qrc/uploads/2018/06/An-image-showcasing-coin-stacks-pointing-towards-what-is-cash-conversion-cyclejpg.jpghttps://quickbooks.intuit.com/in/resources/finance-and-accounting/cash-conversion-cycle-inventory-profits/Small Business Term: What Is Cash Conversion Cycle

Small Business Term: What Is Cash Conversion Cycle

7 min read

Cash Conversion Cycle (CCC) is the time period that your business takes to:

  • convert cash invested in inventories and debtors into
  • cash received from sales

It is important to understand the concept of cash conversion cycle in order to manage your business’ working capital. CCC is an important tool to know your firm’s liquidity or manage current assets and current liabilities.

Now, liquidity means the ability of your company’s assets to get converted into cash quickly to pay for its short-term obligations. It is calculated using some of the important liquidity ratios such as current ratio and quick ratio.

As a result, a business needs to have sufficient cash on it’s balance sheet to pay for current liabilities when they become due. However, liquidity should neither be excessive nor inadequate. This is because having excessive liquidity means piling of funds that are unutilized. Whereas, insufficiency of cash leads to inability of the business to meet short-term debt obligations.

Thus, the cash conversion cycle of your business studied over the years indicates the efficiency of managing working capital. It is used as a measure to compare your business’ performance with regard to the industry competitors.

So, let’s understand what is Cash Conversion Cycle (CCC), what does it indicate and how does it impact your business operations?

Meaning of Cash Conversion Cycle

Cash Conversion Cycle is the time period it takes for a business to convert cash invested in operating activities into cash generated from sales. It measures the time elapsed from the raw materials bought for producing goods to collecting cash from the sale of finished goods. Usually, the process of producing goods involves the following steps:

  • Buying raw materials to manufacture goods
  • Converting raw materials into finished goods
  • Keeping finished goods as inventory
  • Selling finished goods to the final consumer

Now, a business awaits cash payments for selling goods on credit to the final consumer. Therefore, it is important for a business to know the time it takes from procuring the raw materials to receiving cash for the goods produced. This is because it needs to manage its working capital requirements.

How To Calculate Cash Conversion Cycle?

Cash Conversion Cycle involves three components. These include days:

  • Inventory Outstanding
  • Sales Outstanding
  • Payables Outstanding

Hence, we first need to know the various components that define the Cash Conversion Cycle formula. Then, we can understand how cash conversion cycle is calculated. These components are based on the activity or turnover ratios. So, the formula for calculating Cash Conversion Cycle is as follows:

Cash Conversion Cycle Formula = (Days Inventory Outstanding + Days Sales Outstanding) – Days Payables Outstanding

1. Days Inventory Outstanding (DIO)

This is the first phase of CCC that concentrates on the existing inventory level. In addition to this, it indicates how long will a business take to sell its inventory. Lesser the days inventory outstanding, better it is for the business. This is because a lower DIO shows that the company is able to sell its inventory quickly. Thus, it suggests a good turnover of inventory for the business.

Days Inventory Outstanding is calculated based on the Cost of Goods Sold. Cost of Goods Sold is nothing but the cost of procuring or producing goods a business further sells during its normal course. Therefore, following is the Days Inventory Outstanding formula:

Days Inventory Outstanding = 365/Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of goods Sold/Average Inventory

COGS = (Opening Stock + Purchases + Direct Expenses) – Closing Stock

Average Inventory = ½(Opening Inventory + Closing Inventory)

2. Days Sales Outstanding (DSO)

This is the second phase of the CCC that concentrates on the current sales level. Further, it shows how long a business takes to receive cash from customers on goods sold to them. Lower the days sales outstanding ratio, the better it is for the business. This is because a lower days sales outstanding shows that the business is able to receive cash against goods sold in shorter time period. Such a rapid conversion of debtors into cash helps in improving the liquidity position of your business.

Thus, the days sales outstanding is calculated using the days sales outstanding formula. The formula is as follows:

Days Sales Outstanding = 365/Debtors Turnover Ratio

Debtors Turnover Ratio = Net Credit Sales/Average Debtors

Average Debtors = ½ (opening debtors + closing debtors)

3. Days Payables Outstanding (DPO)

This relates to the time period a business takes to make payment to its suppliers or creditors. Longer the time period to pay suppliers, the better it is for the business. This is because longer payment period allows business to hold on to the cash. Furthermore, such cash can be invested in various avenues to generate returns.

Thus, the days payables outstanding formula is as follows:

Days Payables Outstanding Formula = 365/Creditors Turnover Ratio

Creditors Turnover Ratio = Net Purchases/Average Creditors

Purchases = (Ending Inventory – Opening Inventory) + Cost of Goods Sold

Average Creditors = ½(Opening Creditors + Closing Creditors)

Cash Conversion Cycle Example

Let’s consider an example to understand CCC better. Following are the figures from the financial statements of Kapoor Pvt Ltd:

A table representing income statement items to explain what is cash conversion cycle

Following are the figures taken from Kapoor Pvt Ltd’s balance sheet:

A table representing balance sheet items to explain what is cash conversion cycle

Now, let’s assume that purchases are 90% of Cost of Goods Sold to calculate the cash conversion cycle for the year 2018.

1. Days Inventory Outstanding (DIO)

Average Inventory = ½(Opening Inventory + Closing Inventory) = ½(2,200 +3,300) = ½(5,500) = Rs 2,750

Inventory Turnover Ratio = Cost of goods Sold/Average Inventory = 91,000/2,750 = 33.09 days

Days Inventory Outstanding = 365/Inventory Turnover Ratio = 365/33.09 = 11.030 Days

2. Days Sales Outstanding (DSO)

Average Debtors = ½ (opening debtors + closing debtors) = ½(16,800 + 16,200) = ½(33,000) = Rs 16,500

Debtors Turnover Ratio = Sales/Average Debtors = 1,68,000/16,500 = 10.18 Days

Days Sales Outstanding = 365/Debtors Turnover Ratio = 365/10.18 = 35.85 Days

3. Days Payables Outstanding (DPO)

Purchases = 90% x Cost of Goods Sold = 90% x 91,000 = Rs 81,900

Average Creditors = ½(Opening Creditors + Closing Creditors) = ½[(13,200 + 1,200 + 2,300) + (13,500 + 1,300 + 2,100)] = ½(16,700 + 16,900) = ½(33,600) = Rs 25,250

Creditors Turnover Ratio = Net Purchases/Average Creditors = 81,900/25,250 = 3.24 days

Days Payables Outstanding = 365/Creditors Turnover Ratio = 365/3.24 = 112.65 Days

Therefore, Cash Conversion Cycle = (DIO + DSO) – DPO = (11.030 Days + 35.85 Days) – 112.65 Days = – 65.77 Days

As we can see, the CCC of Kapoor Pvt Ltd is negative 65 days. As per theory, the Cash Conversion Cycle of a business can be both positive or negative. Positive CCC shows the number of days for which a company takes goods on credit from its suppliers is less than the days it extends credit to its customers. The aim of every company must be to minimize its cash conversion cycle and if possible, it should be negative. This is because shorter cash conversion cycles mean the business is managing its cash flows efficiently. This is to say that the Cash Collection Period should be less than the Cash Payment Period.

How To Manage Cash Conversion Cycle?

Any changes in its components impacts the Cash Conversion Cycle of the business. As mentioned above, companies should always aim for reducing their CCC. There are various ways in which companies can reduce their Cash Conversion Cycle. Some of them are as follows:

1. Reduce Inventory Conversion Period

Companies can reduce their days inventory outstanding in order to reduce their CCC. Now, business’ need to make procurement, production and selling processes efficient. This is in order to reduce the time period from procuring the raw materials to selling the goods. Furthermore, companies can also avoid stock runouts in order to reduce the inventory conversion period.

2. Increased Credit Payment Period

Companies should pay their suppliers as slowly as possible. But in doing so they should ensure that their credit rating or relationship with the supplier is not impacted. Longer credit period allows the companies to hold on to cash. Such cash can be invested in profitable avenues to generate returns.

3. Reduce Debt Collection Period

This is another way by which companies can reduce their cash conversion cycle. Companies having good relationships with customers are able to collect bills receivable in lesser time. This helps the business in generating cash for their working capital needs.

You May Also Read
Small Business Tip: Manage Accounts Receivables To Boost Cash Flows
4 Ways To Undertake Accounts Receivable Management Successfully

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

Related Articles

Small Business Tip: How to Apply for a Business Loan?

Out of 190 countries, India’s ranking with regards to ease of doing…

Read more

Understanding Liquidity Ratio Analysis

What is Liquidity Ratio Analysis? Liquidity ratio analysis helps in measuring the…

Read more

What is Working Capital? - Meaning, Types & Factors

Working Capital is one of the most important components of business. Business…

Read more