How To Use the Cash Conversion Cycle to Boost Your Bottom Line
Financial ratios can be useful tools for calculating and analyzing business performance. And while you may be familiar with common accounting ratios such as the current ratio, the cash conversion cycle or CCC may not be a ratio that you’re familiar with.
The CCC is an important metric for mid-size businesses. But even if you own a small business, If you purchase and stock inventory for sales, you’ll want to know how quickly that inventory is generating cash.
That’s where the CCC comes in. The CCC looks at your accounts payable (A/P), accounts receivable (A/R), and cost of goods sold (COGS) totals for a select period and uses those totals in a series of calculations designed to provide you with an idea of how efficiently your net operating cycle is. In essence, the ratios indicate how efficiently management is using short-term assets and liabilities to generate cash. This information is useful for both business owners and investors. For business owners, knowing your CCC allows you to make any needed adjustments to your processes, while investors use the CCC to determine the company’s overall health.
Best suited for retailers, the cash conversion cycle provides you with an easy way to analyze inventory movement within your business, with this simple calculation providing you with vital details about your current cash flow as well as your business, including the following:
1.Days inventory outstanding (DIO): The days of inventory outstanding totals or DIO tells you the amount of time your inventory remains in stock before it is sold.
2.Days sales outstanding (DSO): The days of sales outstanding or DSO provides you with some valuable insight into your customer’s payment habits, letting you know exactly how long it’s taking your customers to pay their outstanding invoices. This number is particularly important for those that typically carry a large accounts receivable balance.
3.Days payable outstanding (DPO): The days payable outstanding or DPO gives you a good idea of how quickly your business is turning around its accounts payable balances.
All three of the totals derived from the calculations above are necessary to obtain an accurate CCC. The cash conversion cycle formula is:
DIO + DSO + DPO = CCC
To calculate the CCC for your business, you’ll first need to obtain the following information from your financial statements.
- Total revenue from your year-end income statement
- Total cost of goods sold from your year-end income statement
- Inventory totals from the beginning and ending periods in question
- Accounts receivable totals from the beginning and ending periods in question
- Accounts payable totals from the beginning and ending periods in question
- The total number of days you will use for your calculation
You will need to access two different balance sheets to obtain both beginning and ending totals. For example, if you’re calculating CCC for the entire year, you would need to use your fiscal year balance sheet for the year you’re calculating, as well as for the previous year.
You’ll also need to include the correct number of days in the CCC formula. For example, if you wish to calculate CCC for May, you would take the number of days in May, which is 31, and use that figure in all of your calculations. If you’re calculating CCC for the entire year, you would need to use 365 days in your calculations.
To give you a better idea about calculating and using the cash conversion cycle, take a look at the following example.
Tom owns a large manufacturing plant that produces wiring harnesses for the aviation industry. To better plan for 2021, Tom decides that it could be beneficial to calculate his business CCC for 2020. To get started, Tom should do the following.
Tom’s first step will be to calculate his days inventory outstanding, or DIO. An important calculation for anyone managing inventory, the DIO tells how long inventory is sitting in your warehouse or on the shelf before it’s sold.
To get started, Tom will need to obtain his beginning and ending inventory totals for 2020 from his income statement. In addition, Tom will also need to obtain the total cost of goods sold for 2020. Using the numbers below, Tom can get started calculating his CCC.
|Account||January 2020||December 2020|
|Cost of Goods Sold||N/A||$1,800,000|
For this example, let’s say that Tom’s beginning inventory was $725,000, with an ending inventory total of $625,000, while the cost of goods sold for 2020 was $700,000. With this information now available, Tom can calculate his DIO.
First, he’ll need to calculate his average inventory total for the year.
($725,000 + $625,000) ÷ 2 = $675,000 average inventory
Next, he’ll need to divide the average inventory total by the cost of goods sold for 2020.
($675,000 ÷ $1,800,000) x 365 = 136.8
This means that it takes Tom around 137 days to turn inventory into sales.
Calculate Days Sales Outstanding
With DIO calculated, Tom can move onto the next step, calculating his day’s sales outstanding, or DSO. This calculation will tell Tom the average number of days it takes to collect on his open accounts receivable balances.
To calculate his DSO, Tom will need to first calculate his average accounts receivable balance for 2020. Using the numbers from the chart above, this is the first calculation.
($1,400,000 + $1,070,000) ÷ 2 = $1,235,000 average accounts receivable
Now, Tom can calculate his DIO using the average A/R balance from above and his total credit sales revenue shown on the chart.
($1,235,000 ÷ $5,000,000) x 365 = 90.15
This result means that it currently takes Tom 90 days to collect payment on outstanding invoices.
Calculate Days Payables Outstanding
The final calculation Tom will need to make before calculating his business CCC is the days payable outstanding, or DPO. The DPO is used to calculate the number of days it takes for a business to pay vendors and suppliers.
To calculate DPO, Tom will need to first find his average accounts payable balance for the year. Using the chart above, Tom’s calculation would be as follows.
($380,000 + $410,000) ÷ 2 = $395,000
With this information, Tom can now calculate his DPO
($395,000 ÷ $1,800,000) x 365 = 80.09
This result means that it takes Tom 80 days to pay his suppliers and vendors.
With all three calculations completed, Tom is now able to calculate the CCC for his business. This is done by adding the DIO and DSO totals together and then subtracting the DPO total. Tom’s calculation would look like this.
136.80 (DIO) + 90.15 (DSO) – 80.09 (DPO) = 146.86
Tom’s CCC of 146.86 means that it takes his business almost 147 days to turn his inventory into cash.
“It’s important to look at the three calculations necessary to complete the CCC; the Days Inventory Outstanding, the Days Sales Outstanding, and the Days Payable Outstanding. When viewed and analyzed separately, each can provide you with important details about your business.”
What is a good CCC?
When it comes to the CCC, a lower CCC is always better. A low, or even negative cash conversion cycle result indicates that your business is running efficiently. For example, if you keep minimal inventory on hand or drop-ship products, your CCC will likely be on the lower side while businesses that extend credit to most of their customers will likely have a higher CCC than those that ask for payment upfront.
The higher the number, the more your working capital is tied up, mainly in A/R balances. This may not be too bad if credit terms are extended for 30 days or less, but once credit terms are for 60 or 90 days, your CCC will likely remain high.
If your CCC, like Tom’s above, is very high, there are some things you can do to lower it, while increasing your business efficiency as well. Because cash is the primary driver of your CCC, be sure to look for ways to improve your accounts receivable processes. These improvements may include the following.
- Change customer terms: If you currently offer terms up to 90 days, consider reducing that to 30 days or less.
- Offer an early payment discount: If you give your customers an incentive for paying early, chances are good that some of them will take advantage of that option.
- Consider asking for payment upfront: Instead of offering credit terms to most of your customers, start asking for payment upfront. You can reserve credit terms for your best customers while also ensuring that you receive cash before any inventory being shipped. This may also help reduce the excess inventory you currently have in stock.
- Follow up promptly on past due invoices: If you do continue to offer credit terms to your customers, perform due diligence on any past due invoices. Following up with your customers promptly when an invoice comes due can help avoid a slew of late-paying customers that can drive your CCC up.
What do the results mean?
There are a lot of financial ratios that business owners can calculate to get a real-time view of business performance. The cash conversion cycle is not one of them. Instead, CCC is better used to track business performance over an extended period of time and can also be used to compare your company’s performance against the competition. In addition, a consistent or decreasing CCC points to good management, while a rising or high CCC can point to internal management issues that should be investigated.
While a useful management marker, the CCC is best used for retail companies that purchase and maintain a significant amount of inventory. The CCC is not particularly useful for service and consulting businesses, which will find financial ratios such as the Debt to Equity Ratio or the Return on Equity Ratio much more helpful.
Why the cash conversion cycle is important
For business owners with inventory, running the CCC can be beneficial; particularly if it’s calculated regularly. In addition, if you’re looking for additional financing for your business, be it from a lender or an investor, the CCC is one of the metrics closely looked at. Suppliers may also be interested in your CCC, particularly when they’re deciding whether you’re a good credit risk.
But the CCC metric isn’t just important for outsiders. You can also benefit from taking the time to calculate and appropriately analyze the results of your cash conversion cycle. As mentioned earlier, a low or even negative CCC is a sign that your business is operating efficiently, while a high CCC can point to a variety of issues including inefficient use of inventory supply, lack of demand for inventory products, and poor accounts receivable management, all resulting in lower liquidity.
Poor accounts receivable management, in particular, plays a huge role in a higher CCC, since fewer funds collected means less available for investing in the company. However, delayed payment to vendors and suppliers will allow you to hold onto those funds longer, boosting available working capital.
How to use the cash conversion cycle in your business decisions
The cash conversion cycle provides you with a metric that can provide useful details about your business, but only if you calculate it regularly.
When calculating the CCC for your business, it’s also important to look at the three calculations necessary to complete the CCC; the Days Inventory Outstanding, the Days Sales Outstanding, and the Days Payable Outstanding. When viewed and analyzed separately, each can provide you with important details about your business.
Used as a reliable marker for past and current business performance, your company’s cash conversion cycle results can also be compared to those of your competitors. In any case, using this metric to strategize about ways to sell your inventory, collect your accounts receivable balances, and pay your bills can go a long way towards making your business a much more efficient operation.
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