Investors have a wealth of financial ratios they can examine to better understand the health of a company. One of the most important measures of management efficiency is the cash conversion cycle, which tells the analyst 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 article, 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.
The cash conversion cycle is a measure of a company's ability to move cash through a process 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 performance, comparisons should be made between companies in similar industries. As the cash conversion formula is examined in more detail, the reasoning behind this statement will be clearer.
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
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, participating in similar industries.
The formula also provides insights into the power of this measure. When making comparisons between companies, each of the three components can be evaluated separately. For example:
In the table below is information for two companies (actual data) in what has been traditionally a very competitive industry. Each of these companies is a highly-regarded and profitable business.
|Company A||Company B|
|Cost of Goods Sold||39,541||15,577|
|Average Accounts Receivable||5,510||14,987|
|Average Accounts Payable||12,015||4,197|
|Days Inventory Outstanding||9.7||32.1|
|Days Sales Outstanding||30.83||78.21|
|Days Payable Outstanding||110.9||98.3|
|Cash Conversion Cycle||(70.4)||12.0|
From the above data, it's possible to make the following observations about these two companies:
The above example illustrates the thought process the analyst should go through when examining the differences in the cash conversion cycle of two companies. It's possible to make these types of comparisons using our Cash Conversion Calculator. That online tool, along with the information readily available on websites such as Google Finance, allows investors to quickly compare the cash conversion performance of the companies they're evaluating.
About the Author - Understanding the Cash Conversion Cycle - Copyright © 2011 - 2015 Money-Zine.com (Last Reviewed on December 28, 2015)