The cash conversion cycle (CCC) is an important metric for a business owner to understand. The CCC is also referred to as the net operating cycle. This cycle tells a business owner the average number of days it takes to purchase inventory, and then convert it to cash. That is, it measures the time it takes a business to purchase supplies, turn them into a product or service, sell them, and collect accounts receivable (if needed).
The CCC time is dependent upon how a company finances its purchases, how it allows customers to pay (credit and the collection period), and how long it takes to collect.
A lower CCC is an indicator of a faster inventory-to-sales process. A higher CCC indicates a slower process. A low CCC is generally accepted as more desirable, although this depends on your business, industry, and capabilities.
Elements of the Cash Conversion Cycle
Calculating the CCC may seem intimidating at first, but once you understand the elements involved in the calculation, it isn't as confusing.
You'll need to reference your financial statements such as the balance sheet and income statement to give you information for the calculations. The cash conversion cycle formula has three parts: Days Inventory Outstanding, Days Sales Outstanding, and Days Payable Outstanding.
Days Inventory Outstanding
The first part of the equation is Days Inventory Outstanding (DIO). This is the average time to convert inventory into finished goods and sell them.
DIO = (Average Inventory ÷ Cost of Goods Sold) x 365
Your average inventory (in value) for the period is your beginning inventory value + ending inventory value ÷ 2.
(Beginning Inventory + Ending Inventory) ÷ 2
The cost of goods sold is:
Beginning Inventory + Purchases - Ending Inventory.
Days Sales Outstanding
Days Sales Outstanding (DSO) is the average amount of time in days that your accounts receivable (your business is owed money) are waiting to be collected.
DSO = (Accounts Receivable ÷ Net Credit Sales) x 365
Your accounts receivable for this element are the average of your beginning and ending receivables.
(Beginning Receivables + Ending Receivables) ÷ 2
Days Payable Outstanding
The Days Payable Outstanding (DPO) is the average length of time it takes a company to purchase from its suppliers on accounts payable—your business owes money—and pay for them.
DPO = Ending Accounts Payable ÷ (Cost of Goods Sold ÷ 365)
Accounts payable in this element is:
(Beginning Payable + Ending Payable) ÷ 2.
Calculating the Cash Conversion Cycle
Once you have calculated all three of the required elements of the formula, you can calculate the CCC.
Cash Conversion Cycle (CCC) = DIO + DSO - DPO
Using the Cash Conversion Cycle
The CCC is good information, but really only useful if you are calculating it every year and comparing it—along with the three elements of the formula—to your business' past performance.
You may be able to compare your CCC to your competitors if their financial information is available. If it is not, you can use this metric to develop strategies to improve the time it takes to sell your inventory, collect on receivables, and pay your bills.