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When you’re trying to get a sense of your business’s financial health, you’ll come across what’s called the cash conversion cycle. Unfortunately, 82% of small businesses fail due to cash flow problems. If you’re struggling to cover expenses or make it to the end of the month or year, it’s time to take action. By understanding the cash conversion cycle, you can get a better idea of your cash flow to help you budget. In this article, we’ll explore how you can use the cash conversion cycle formula to calculate your business’s. Read on to see how an understanding of CCC can help your business and what a negative cash conversion cycle means.
What is the Cash Conversion Cycle?
The cash conversion cycle or CCC is a figure that demonstrates the average amount of time (in days) it takes to see cash after you purchase inventory. The calculation is based on your cash flow over a one-year period. It’s also known as the net operating cycle, or just cash cycle for short. The cash conversion cycle is an important metric for business owners to track. Knowing your CCC allows you to fully understand the way cash flows through your business. This in turn will help your business create a budget or restructure your financial plan.
Calculating the Cash Conversion Cycle
To calculate the cash conversion cycle you’ll need three metrics: The Days Inventory Outstanding (DIO), the Days Sales Outstanding (DSO), and the Days Payable Outstanding (DPO). To get those metrics, you’ll need to have your financial statements (i.e., your balance sheet and income statement) ready to go.
At a glance, the cash conversion cycle formula looks like this:
Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding
Next, you’ll see how to get those three metrics and make the calculation yourself.
Days Inventory Outstanding (DIO)
The Days Inventory Outstanding (DIO) metric is a measure of the average amount of time it takes you to purchase inventory and sell it as a final product.
The Days Inventory Outstanding” (DIO) formula looks like this:
DIO = (Average Inventory ÷ Cost of Goods Sold) x 365
To complete this calculation, you’ll see that you need two numbers: Your average inventory and cost of goods sold. Here’s how to get those:
- Average Inventory for the year you’re analyzing is: (Beginning Inventory + Ending Inventory) ÷ 2
- Cost of Goods Sold for the year you’re analyzing is: Beginning Inventory + Inventory Purchases – Ending Inventory
Days Sales Outstanding (DSO)
The Days Sales Outstanding metric (DSO) is a metric that tells you how long it takes for you to get paid by your customers after making a sale. This is otherwise the average number of days it takes your accounts receivable to close.
The Days Sales Outstanding (DSO) formula looks like this:
DSO = (Accounts Receivable ÷ Net Credit Sales) x 365
To complete this calculation, you’ll see that you need two numbers: Accounts receivable and net credit sales. Here’s how to get those:
- Accounts Receivable for the year you’re analyzing is: (Beginning Receivables + Ending Receivables) ÷ 2
- Net Credit Sales for the year you’re analyzing is: Sales Made to Customers on Credit – Credit Returns
Days Payable Outstanding (DPO)
The Days Payables Outstanding metric (DPO) is a formula that tells you how long it takes for your business to pay creditors. This also means how many days it takes for you to pay your suppliers from the point of purchase.
The Days Payables Outstanding (DPO) formula looks like this:
DPO = Ending Accounts Payable ÷ (Cost of Goods Sold ÷ 365)
To complete this calculation, you’ll notice that you need two numbers. They are ending accounts payable and cost of goods sold. Here’s how to get those:
- Accounts Payable for the year you’re analyzing is: (Beginning Payable + Ending Payable) ÷ 2.
- You should already have calculated the Cost of Goods Sold from the DIO section. It’s (Beginning Inventory + Inventory Purchases – Ending Inventory)
Once you reach the end, you’ll have DIO, DSO, and DPO that you’ll be able to plug into the initial Cash Conversion Cycle formula (CCC):
Cash Conversion Cycle (CCC) = DIO + DSO – DPO
The CCC unit of measure is days. So, if your result is 10 for example, it means your CCC is 10 days.
What Does a Negative Cash Conversion Cycle Mean?
When you get to the end of the calculation, you may realize your answer is negative. Now you’re wondering, what does a negative cash conversion cycle mean? Let’s explore that next.
A negative cash conversion cycle essentially shows you how long you have cash before you need more. It’s the amount of time you’ll have cash on hand to finance your operations before you need to cover expenses. Having a long stretch between cash in and cash out can be a good thing as you grow and scale. It’s also a sign of good cash flow projection tactics.
A negative cash conversion cycle means your business has longer to pay creditors (like bills and suppliers) than it takes to get paid by customers. In practice, this means that your suppliers are technically financing your business operations. Therefore, you don’t need more cash in order to grow or expand.
Conversely, a positive CCC means that your business needs more cash on hand to cover expenses and grow. If this is the case, timing your receivables and payables should be a priority.
What can be Learned from the Cash Conversion Cycle Formula
Essentially, the cash conversion cycle is a number that helps you to identify how much cash your business needs to grow. The formula helps you see where you’re currently at. In general, a lower number is better than a higher one.
The lower your cash conversion cycle number is, the easier it will be to grow on your own with the cash you have on hand. The higher your number, the more challenging it will be to grow from where you are today with cash. You may instead require outside support, like business funding or an investor.
Now you may be wondering, “how can I reduce my CCC?” To reduce your CCC number you’ll need to:
- Reduce the level of inventory you hold in stock at any given point in time
- Reduce your accounts receivable by having your customers pay you quicker through better invoice management
- Increase accounts payable by negotiating longer payment terms with suppliers
Closing Thoughts on the CCC
The cash conversion cycle formula is a tool that shows you how quickly you can convert assets into cash. For small businesses, too long of a cash conversion cycle can lead to bankruptcy. A big gap in cash out vs. cash in leaves the potential for your business to fail to pay bills each month. This is why CCC is one of many metrics that help you understand and manage your assets. However, it does not paint the whole picture. If you’re looking to assess your business’s financial health further, you can use this number to perform an entire cash flow analysis.
While it seems like a daunting metric to calculate, it’s a relatively simple calculation once you understand what you’re doing. It’s important to calculate the cash conversion cycle for your business each year. By doing so, you can stay on top of your asset management. This will help you see how your business asset management trends have changed or where they need to change.