accounting

What is the cash conversion cycle? How to understand and calculate CCC

Cash is king, and no business can operate for long without generating sufficient cash inflows. The cash conversion cycle (CCC) is a great metric to assess how well you manage cash. It’s a complicated formula, and you need to understand accrual accounting and working capital to use it.

Once business owners understand the cycle, they can make improvements to increase cash collections and thereby reduce the need to borrow money to operate. So, what exactly is the CCC?

What is the cash conversion cycle?

The CCC is a measure of the length of time it takes a company to convert investments in inventory or other costs of goods sold into cash flow from sales. The CCC is sometimes called the net operating cycle or cash cycle.

The CCC measures how well your company manages accounts receivable, inventory turnover, and accounts payable. These three accounts may be large account balances, and each has an impact on cash.

Generating a profit is important, but even profitable businesses struggle if they can’t collect cash fast enough. The CCC measures how well you manage cash.

Why is the cash conversion cycle important?

The cash conversion cycle is important because it helps businesses measure operational efficiency. By understanding the CCC and taking action to improve on the factors involved, business owners can avoid taking on additional debt or issuing stock to improve liquidity.

It’s important to note that the CCC is only applicable to businesses that depend on inventory management, such as retailers and e-commerce businesses.

Using the CCC formula requires a basic understanding of both accrual accounting and working capital.

All businesses should use the accrual basis of accounting so that revenue is posted when it is earned and expenses are posted when they are incurred. Using this method matches revenue earned with the expenses incurred to generate the revenue, and the system presents a more accurate view of your profitability.

Accrual accounting requires you to post accounts receivable and accounts payable balances, both of which are used in the CCC formula. When you sell an item and don’t receive cash from the customer, you increase accounts receivable. Accounts payable, on the other hand, increases when you receive a bill and don’t pay it immediately.

Accounts receivable and accounts payable are two components of working capital.

Working capital equals current assets less current liabilities, both of which are included in the balance sheet. Your goal is to generate more current assets than current liabilities so that the formula always produces a positive number.

The CCC uses several current asset and current liability balances. Accounts receivable and inventory accounts are current assets, and accounts payable is a current liability balance.

You can improve the CCC by lowering the number of total days in the formula. If the amount of time decreases, you’re doing a better job of managing working capital.

Account balances that reduce your cash balance

In most businesses, accounts receivable and inventory are large balances, and these accounts tie up your available cash. Here’s why:

  • When you sell goods and services and don’t collect cash immediately, you increase the accounts receivable balance. The longer an accounts receivable balance is outstanding, the less cash you have to operate.
  • If you decide to carry a higher inventory balance, you’ll also have less cash to operate. When inventory is sold, the balance is recorded as cost of goods sold (COGS). Until you sell the inventory and collect cash, you’ll have a lower cash balance.

As you’ll see below, both accounts receivable and inventory balances are used to calculate the CCC.

How to calculate the cash conversion cycle

The CCC includes three components, which are explained below. Each component’s formula defines the average balance as the sum of the beginning balance plus the ending balance divided by two.

In each formula below, the number of days in the period is 365 (one year), but you can calculate the CCC using a different amount of time as needed (for example, quarterly).

Understanding days inventory outstanding

Days inventory outstanding (DIO) is the average number of days required to convert inventory into sales. DIO is also defined as the average number of days that a business owns inventory before selling it. The DIO calculation is average inventory divided by cost of goods sold multiplied by 365. You can find the cost of goods sold on the income statement.

Here’s the formula:

DIO = (Average inventory ÷ cost of goods sold) x 365

Where:

Average inventory = (1/2) x (BI + EI)

BI = Beginning inventory

EI = Ending inventory

Reviewing days sales outstanding

Days sales outstanding (DSO) is defined as the average number of days it takes to collect payment following a sale on credit. The DSO calculation is average accounts receivable divided by total credit sales multiplied by 365. Here’s the formula:

DSO = (Average accounts receivable ÷ total credit sales) x 365

Reviewing days payables outstanding

Days payable outstanding (DPO) is the average number of days your business takes to pay an accounts payable balance. When you purchase goods and services and don’t pay cash immediately, you post an accounts payable balance (a liability account). The DPO calculation is the average accounts payable balance divided by cost of goods sold, multiplied by 365. The formula is:

DPO = (Average accounts payable ÷ total cost of goods sold) x 365

Using the abbreviations explained above, the CCC is DIO plus DSO less DPO. DPO is subtracted because you control when vendors are paid. Businesses must balance the need to conserve cash (by delaying payment) with the need to keep good relationships with vendors by paying on time.

Cash conversion cycle formula and example

To calculate the conversion cycle, we’ll use Sterling Manufacturing’s data from this chart:

Cash conversion cycle calculator Google Sheet

You can use this calculator to find your cash conversion cycle:

  1. Open the sheet and make a copy.
  2. Replace the company name in the header section with your business name, and update the period to reflect the period you’re analyzing.
  3. Replace the data in average accounts receivable, annual credit sales, average inventory, annual cost of goods sold, and average accounts payable with your own.
  4. The sheet will automatically calculate the DSO, DIO, DPO, and cash conversion cycle.

Here are the calculations, using Sterling Manufacturing’s data:

  • DIO is $250,000 average inventory divided by $1,600,000 cost of goods sold multiplied by 365, or 57 days
  • DSO is $300,000 average accounts receivable divided by $2,000,000 annual credit sales multiplied by 365, or 55 days
  • DPO is $150,000 average accounts payable divided by $1,600,000 cost of goods sold multiplied by 365, or 34 days

The CCC calculation is 57 DIO plus 55 DSO less 34 DPO, or 78 days.

Assessing the number of days depends on your industry and how well you manage accounts receivable, inventory, and accounts payable.

Evaluating your cash conversion cycle

Compare your CCC result to other companies in your industry. A negative CCC means that you carry low accounts receivable and inventory balances compared to sales. Your customers pay you quickly, and you carry just enough inventory items to fill customer orders. Finally, you do a good job managing accounts payable.

Businesses with a positive CCC carry larger accounts receivable and inventory balances, and may be paying accounts payable balances faster than is necessary.

If your cycle takes more days than your competitors, find out why.

What is considered a good cash conversion cycle?

A lower CCC is generally better. A negative or low CCC indicates that your company is converting inventory into sales quickly and efficiently.

If you find your CCC is high, you can take action to improve collections, inventory management, and your handling of accounts payable.

Why you’re not collecting cash fast enough

Here are the factors that slow down cash collections:

  • Accounts receivable: You need to do a better job of collecting accounts receivable.
  • Inventory: You may be carrying a bigger inventory balance than is needed to fill customer orders.
  • Accounts payable: The business is paying accounts payable balances sooner than the due dates require.

The final reason relates to the sales process. Growing sales is great, but if your accounts receivable balance is growing at a faster rate than sales, you may start to run short on cash. Take action to increase cash collections or reduce the number of days in the cycle.

How to speed up cash collections

These steps will help you collect cash sooner and reduce the CCC:

1. Create a cash flow roll forward

Find out where you stand now. Forecast your cash inflows from sales and your required cash outflows by month. Each month’s beginning cash balance plus cash inflows, less cash outflows, equals your ending cash balance. If your plan for the next six months indicates a negative cash balance, you know that you’re not collecting cash fast enough. Once you know the extent of the problem, you can take action.

2. Monitor accounts receivable

Generate an accounts receivable aging schedule each month. The report lists the dollar amounts you’re owed based on the date of the invoice. Aging reports typically group invoices based on 0–30 days old, 31–60 days old, etc. Older invoices present a higher risk of nonpayment.

3. Enforce a collections policy

You should have a written policy for collecting money, and the policy must be enforced to increase cash inflows. You might email each client when an invoice is 30 days old and call on invoices when they reach 60 days old. If a customer pays late on every sale, consider whether you should do business with the client.

4. Manage inventory purchases

If inventory is a large component of your cash outflows, monitor your purchases closely. Buy enough inventory to fill customer orders but not so much that you deplete your bank account.

5. Offer discounts

Offer customers a discount (1%–2%) if they pay within five days of receiving the invoice. You’ll collect money faster, which may be more valuable than the 1% to 2% you lose when the customer takes the discount.

6. Accept electronic payment, credit, and debit cards

Make it easy for customers to pay you by offering electronic payment methods on your website. Accept credit and debit cards, and email customers an invoice with a link to your payment portal.

7. Pay vendors on time

Maintain good relationships with your vendors by paying them on time. If you’re able to speed up your cash inflows, you can make timely payments and maintain a sufficient cash balance.

If you implement these changes, you’ll collect cash much faster and you can avoid the need to raise more money for operations.

What’s the difference between working capital cycle and cash conversion cycle?

The working capital cycle is slightly different than the cash conversion cycle. The working capital cycle measures how long it takes to convert working capital (current assets less current liabilities) into cash.

As explained above, the CCC includes three accounts that are either current assets or current liabilities. Accounts receivable and inventory are current asset balances, while accounts payable is a current liability account.

The working capital cycle includes additional accounts, including prepaid assets (a current asset account) and the current portion of long-term debt (a current liability account).

So, which formula do you use? The working capital cycle includes more accounts, but the cash conversion cycle includes the largest account balances in working capital. Most companies use the cash conversion cycle because accounts receivable, inventory, and accounts payable are the largest portion of working capital.

So, what are your next steps?

Making decisions using the cash conversion cycle

Use accounting software to generate your company’s cash conversion cycle, and take action to lower the number of days in the calculation. Technology helps you perform more detailed analysis in less time. Sign up for our free webinar to learn more about financial reports with QuickBooks Advanced.


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