Converting Resources Into Cash Flows
How do you calculate the cash conversion cycle?
The cash conversion cycle is one of the most important metrics that a business owner should calculate when conducting a cash flow analysis of a company. All other things held equal, it is better to have a shorter cash conversion cycle rather than a longer one. It is a measure of your company's liquidity, but also much more than that.
The Cash Conversion Cycle
The cash conversion cycle (CCC) is a process or a cycle where the company purchases inventory, sells the inventory on credit as an account receivable, and then collects the account receivable or turns it into cash. The company needs to cash to pay its own bills. The cash conversion cycle looks at the time tied up in converting inventory and receivables to cash, as well as the amount of time the company is given to pay its bills without incurring any penalties.
It is vital that the business owner calculate the cash conversion cycle. It tells the owner the number of days that cash or capital stays tied up in the business processes of the firm. The cash conversion cycle is a measure of working capital efficiency.
Calculating the Company's Cash Conversion Cycle
The cash conversion cycle calculation has three parts: inventory, receivables, and payables. In order to calculate the cash conversion cycle, you first have to calculate the conversion period for inventory and receivables and the deferral period for payables.
The inventory conversion period is the average time to convert inventory into finished goods and to sell those goods. Here is the formula:
Inventory conversion period = Inventory/Sales per day = # days
The receivables collection period is also called Days Sales Outstanding (DSO) or Average Collection Period. It is also stated as a number of days. Here is the formula:
Receivables Collection Period (DSO) = Receivables/Sales/365 = # Days
The Payables Deferral Period is the average length of time between when a company purchases supplies, materials, and labor from its suppliers on accounts payable and when it pays for them. Here is the formula:
Payables Deferral Period = Payables/Cost of Goods Sold/365 = # Days
Cash Conversion Cycle (CCC) = Inventory Conversion Period + Receivables Collection Period - Payables Deferral Period
It essentially shows the business owner or financial manager the length of time a dollar is tied up.
Manipulating the Cash Conversion Cycle for Your Needs
Businesses quickly learn that they can manipulate the cash conversion cycle to their benefit. What you want to do is shorten the cash conversion cycle so that your money is not tied up in the production process any longer than necessary. You can shorten the cash conversion cycle by reducing the inventory conversion period and the receivables collection period. How do you do that?
Try to speed up the production process by processing and selling goods more quickly and speed up the collection of receivables. Regarding payables, slow down your payments but don't incur late charges. Shortening the cash conversion cycle will free up more working capital for your business.