Cash Conversion Cycle: How Long a Company's Money Is Tied Up in Operations

What Is the Cash Conversion Cycle?

In plain words, what is cash conversion cycle? It is the number of days from paying for inventory till collecting the cash from selling it.

An important detail to remember: it is cash tied up in operations, not money lost or locked somewhere else. All the money within the cycle belongs to the company. It is simply kept as inventory or an unpaid invoice rather than in the bank account, and so it can't be spent on employees' salaries, purchases, or debt servicing till it moves through the cycle.

This is why the metric is measured in days rather than dollars. When asking what is a cash conversion cycle, we ask, in fact, how long the company has to wait for its own money.

Cash Conversion Cycle Formula

The cash conversion cycle is calculated with the following formula consisting of two additions and one subtraction:

CCC = DIO + DSO - DPO

Days Inventory Outstanding

DIO is the indicator of how long the company keeps inventory before selling it. Divide average inventory by cost of goods sold and multiply the result by 365.

We use the cost of goods sold, not revenue as the denominator, as inventory is accounted for at its cost. Otherwise, the figure will be understated. DIO is the same as the inventory turnover measure represented differently. A turnover of six times a year means the DIO of about 61 days.

Days Sales Outstanding

DSO is the duration of the process of collecting payments from the clients who have made the purchase. Divide average accounts receivable by revenue and multiply the result by 365.

Revenue is the denominator in this case as accounts receivable are recorded at the selling price. In theory, the denominator should be credit sales, not revenue, since cash transactions don't generate an account receivable. This distinction is rarely seen in published accounts, as a rule. Therefore, total revenue is used. Because total revenue is the larger figure, this proxy understates the true collection period on credit sales, and the gap widens for a company with a considerable percentage of cash sales.

Days Payable Outstanding

DPO measures the duration of time required to pay off the company's suppliers. The calculation consists of dividing average accounts payable by cost of goods sold and then multiplying the result by 365.

In theory, the denominator should be purchases, not cost of goods sold. The two are different by the change in inventory over the period. Purchases are not disclosed by the company, and cost of goods sold is used as a proxy. It is usually quite accurate unless the inventory changed dramatically during the period. Lengthier supplier payment terms increase DPO and shorten the cash conversion cycle, and the reason behind the change matters more than the number itself.

Cash Conversion Cycle vs Operating Cycle

The operating cycle is equal to DIO plus DSO, as it covers the period of time from purchasing inventory till collecting the money from selling it, without considering how this inventory has been purchased.

The cash conversion cycle takes that period and subtracts DPO, which represents the portion of the operating cycle financed by the company's suppliers instead of by the company. The operating cycle reflects the physical process, and the cash conversion cycle is the one describing the finance.

How to Calculate a Company's Cash Conversion Cycle

Finding the Inputs in Financial Statements

The five numbers and two statements:

• Balance sheet: inventory, accounts receivable and accounts payable at both opening and closing dates;

• Income statement: revenue and cost of goods sold for the period between the dates specified above.

The opening balances can be found in the comparative column, which is why all the information necessary for calculation is usually located in one annual report.

Using Average Balances and Consistent Periods

Balance sheet values represent the balances of the single day, whereas the revenue and cost of goods sold values refer to the whole year. Combining the two will produce a result dependent on what was left on the balance sheet at year-end.

Thus, take averages of the balances, and use the consistent period of time. Annual flows should be combined with 365 days, while a quarter should be combined with 91. Pairing a full year of cost of goods sold with a single quarter's multiplier is what leads to an incorrect result.

Another thing to consider when measuring the cycle for a seasonal business. The retailer, whose fiscal year ends on January 31, will have minimum inventory, and so the DIO value will be considerably underestimated. Comparison of the same company on the same date each year is the way out.

A Worked Company Example

Let's assume that we have a hypothetical consumer goods manufacturer. It reports revenue of $1,095 million and cost of goods sold of $730 million, meaning that the company makes about $3 million of sales per day and incurs $2 million of cost per day. The company maintains average inventory of $120 million, average receivables of $135 million, and average payables of $80 million.

1. DIO: $120 million divided by $2 million per day equals 60 days.

2. DSO: $135 million divided by $3 million per day equals 45 days.

3. DPO: $80 million divided by $2 million per day equals 40 days.

4. CCC: 60 plus 45 minus 40 equals 65 days.

Operating cycle is 105 days, with 40 days of funding provided by the suppliers and 65 days financed by the company itself. In dollars, the total amount involved in the cash conversion cycle is $175 million: $120 million of inventory and $135 million of receivables, offset by the $80 million which the company owes but hasn't paid yet.

What Is a Good Cash Conversion Cycle?

There is no universal standard value for cash conversion cycle. Anyone who claims otherwise avoids the main question, because what is a good cash conversion cycle depends on three factors:

• the industry: a grocery retailer has a short DIO and collections at the checkout, while an aircraft manufacturer keeps its work in progress for months. Such discrepancies reflect the industry-specific features, not the company's performance;

• the trend: the best way to compare is the same company measured during several years as its business model remains the same;

• the business model: a software company will have almost zero DIO due to absence of physical inventory, and so the cash conversion cycle of such business will be driven by the collections.

Therefore, treat it as a relative measure. Compare with similar companies and with the historical values of the same company, because the widening of the cycle raises questions worth asking while the narrowing requires further investigation of the cause.

Positive, Zero and Negative Cash Conversion Cycles

A positive cash conversion cycle means that the company pays its suppliers before collecting from its clients and funds the resulting gap on its own. This kind of funding comes either from retained cash, overdraft or borrowing, which is a way in which the operating metric becomes a balance-sheet figure. How it will be viewed by the lender is covered in the piece on corporate bonds and how corporate debt is rated.

A cycle of zero means that DIO plus DSO is equal to DPO, meaning that the supplier terms cover the whole operating cycle, and nothing is funded by the company.

Negative cash conversion cycle isn't an error in accounting and this is what confuses many people. It means that the company collects from the customers before having to pay its suppliers. This happens regularly in grocery and discount retail: stock turns over in a few weeks, customers make a payment at checkout and so the receivables are low, and the suppliers operate on the terms of 45 or 60 days. The company with DIO of 30 days, DSO of 2 days and DPO of 45 days has the cycle of minus 13 days. Suppliers finance the business operations of such company, and it holds the customers' cash before settling its own bills.

What a Longer CCC Reveals About Operations

A lengthening cash conversion cycle means that you need to look into which of the three components moved, as they each point in a different direction.

• Increase in DIO means that the inventory is turned slower. It may be caused either by low demand, or deliberate building of the inventory in anticipation of some new product launch.

• Increase in DSO means that the clients pay longer. This may be a sign of weak clients or lenient terms offered in order to get additional sales.

• Decrease in DPO means that the company pays faster either for discounts or due to tough terms of its suppliers.

None of them by themselves is a conclusion. Increasing the length of the cycle means that more capital is involved in generating the revenues, which is the same issue as that addressed by the asset turnover ratio from another perspective.

How to Improve and Reduce the Cash Conversion Cycle

There are only three handles, one for each of the components. The practical question of how to improve cash conversion cycle performance is whether a handle can be moved without doing harm to anything else.

1. Inventory: improve forecasting, reduce the slow-moving items, which will reduce DIO. If you cut too far, the stockout will eat your sales.

2. Collections: improve the credit checking, issue invoices in time and make follow-ups, which will shorten the collection period. Be careful not to make the terms too strict, as this may drive away the customers to the competitors.

3. Supplier payments: extend the payment terms, which will raise DPO and decrease the cycle. Be careful not to hurt the relations with the suppliers, lose discounts or signal financial stress.

Thus, how to reduce cash conversion cycle length isn't the same question as running the business in a more efficient way. Here working capital management goes beyond simple arithmetic: the first two handles typically improve the efficiency, and the third one simply shifts the burden onto someone else's balance sheet.

Cash Conversion Cycle Before and After Operational Changes

Same company, same revenue. The table below varies the value of one of the three components at a time and then all three at once.

Overall, all three changes decreased the cash conversion cycle by 27 days and released $61m of cash, from $175m to $114m. And this is real money received by the company without selling additional units.

However, the warning here is the way in which it has been achieved. Two of the three changes reflect the improved performance of the company, while the third one, extension of the payment terms by ten days, improves the ratio by $20m without affecting operations at all. Both of the approaches decrease the cycle, but they are not the same, which is why the decreased cycle shouldn't be considered as an indicator of a healthier business without understanding which handle has been used to achieve it.

Using CCC as an Operational Efficiency Filter on Pocket Option

It is a slow-moving metric derived from quarterly accounts, so it isn't a timing tool and it doesn't give you an idea of the direction of changes. What it does provide is background information on the level of efficiency of the company's operations.

1. Use the same approach in calculating the cash conversion cycle for every company you compare, averaging balances and taking into consideration the proxies as mentioned above.

2. Track four to eight quarters instead of a single one. A single reading isn't a trend.

3. Find out which component has changed before coming to any conclusions, because three components carry different meanings.

Treat it as one of the inputs. The deteriorating cycle during several quarters may be a sign of operational problems which haven't yet affected the profits. That is useful context when deciding the position size, rather than a reason to expect a particular price move, and fitting it into a documented process is described in this guide to building a realistic trading plan.

Conclusion

The cycle measures days, and these days are the time period during which the company has to wait for its own money.

Calculate it correctly and use the comparisons: average balances, consistent periods of time, cost of goods sold for inventory and payables, revenue for receivables, and remember which proxies you've used. Interpret the result comparing with the industry and with the company's own historical values, not with any universal standard. Negative cycle is a normal business model, not an error, and a decreasing cycle requires a closer look at which of the three handles has moved.

Disclaimer: This article is provided for informational and educational purposes only and does not constitute investment or financial advice. The company figures used are hypothetical and chosen to illustrate the calculation, not real data. Financial ratios reflect past reported periods and do not predict future performance or share price movements, and accounting treatments and disclosure practices may differ between companies and countries. Trading involves a significant risk of capital loss and may not be suitable for all investors, and results obtained on a demo account do not indicate future results in live trading.