Understanding the Cash Conversion Cycle

As investors, we have a wealth of financial ratios we can examine to better understand the economic health of a company. One of the measures of management efficiency is the cash conversion cycle, which tells us how much cash the company has tied up in inventory, its ability to collect money owed from customers, as well as the time it takes to pay certain creditors.

In this publication, we're going to be covering the topic of the cash conversion cycle (CCC).  As part of that discussion, we'll talk about the usefulness of the measure, each of its components, as well as its calculation.  Then we'll finish with an example, including a link to an online cash conversion calculator.

Cash Conversion Cycle

The cash conversion cycle is a measure of a company's ability to move cash through a cycle that starts with the purchase of materials from suppliers, and ends with the collection of money from customers.  The faster a company can convert cash spent into cash received, the more efficient the process, and the greater the ability of a company to generate additional profits.

When benchmarking a company's cash conversion cycle performance, comparisons should be made between companies in similar industries.  As we take a closer look at the cash conversion formula, the reasoning behind this statement should be clearer.

Cash Conversion Cycle Formula

The calculation of the cash conversion cycle requires information from both the balance sheet (inventories, accounts receivable or A/R, and accounts payable or A/P) as well as the income statement (cost of goods sold or COGS, and revenues).  This information is then used to calculate three metrics:  Days Inventory Outstanding (DIO), Days Sales Outstanding (DSO), and Days Payable Outstanding (DPO), as demonstrated in the formula below:

Cash Conversion Cycle (CCC) = DIO + DSO - DPO

where:

DIO = Average Inventory / (Cost of Goods Sold / 365)
DSO = Average Accounts Receivable / (Revenues / 365)
DPO = Average Accounts Payable / (Cost of Goods Sold / 365)

and:

Average Inventory = (Beginning Inventory + Ending Inventory) / 2
Average Accounts Receivable (A/R) = (Beginning A/R + Ending A/R) / 2
Average Accounts Payable (A/P) = (Beginning A/P + Ending A/P) / 2

The CCC formula relies on the COGS, inventories, as well as payment patterns from customers, and to suppliers.  These variables can vary significantly between industries.  That's the reason benchmarks must be aligned with competitors or companies within similar industries.

The formula also provides us with insights into the power of this measure.  When making comparisons between companies, each of the three components can be evaluated separately.  For example:

• Days Inventory Outstanding (DIO) tells us how efficiently a company turns its inventory into revenue.
• Days Sales Outstanding (DSO) tells us how effective the company is at collecting money from customers after a sale.
• Days Payable Outstanding (DPO) tells us how quickly a company pays its suppliers.  This is often indicative of the relationship the company has with its trade partners.

 Cash Conversion Cycle Example

Now that we've discussed the usefulness of the CCC measure, as well as its calculation, let's finish this topic with an example.   Here we're going to examine two companies (actual data, names changed) in what has been traditionally a very competitive battle for two highly regarded and profitable businesses.

From the above data, we can make some observations about these two companies:

• Company A is a very efficiently run business.  They have less than ten days of inventory on hand.  They also have a great relationship with their suppliers, allowing them to carry very favorable credit terms (111 days).  They are also very good at collecting money owed from customers.
• Company B is also an efficiently run business.   They have a little over a month's worth of inventory.  They also have a very good relationship with suppliers, allowing them to pay back money owed an average of nearly 100 days.  Where they suffer competitively is their ability to collect money from customers, which is nearly 40 days longer than Company B.

The above example illustrates the thought process an analyst can go through when examining the differences in the cash conversion cycle of two companies.  If you'd like to make some comparisons yourself, you can use our Cash Conversion Calculator.  That online tool, along with the information readily available on websites such as Google Finance, allows you to quickly compare the cash conversion performance of the companies you're evaluating.

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