Cash Cycle Conversion: Definition and How To Calculate It

By Andrew Juma

Updated October 4, 2022 | Published February 15, 2021

Updated October 4, 2022

Published February 15, 2021

Andrew Juma writes on various issues, including taxation, pensions and HR topics for various companies. He also produces training materials in areas such as leadership, talent management and performance management.

The cash cycle conversion helps companies understand their working capital position and manage it effectively. Businesses need to know how much cash they're using and when they're using it so that they can plan their funding requirements accordingly. Understanding the cash cycle conversion may help you identify opportunities for improving cash flow and managing risk so you can assist a company in meeting its financial obligations when they're due.

In this article, we explain what the cash cycle conversion is, when to evaluate it, why it's important and how to calculate it.

What is the cash cycle conversion?

The cash conversion cycle (CCC) is a financial metric that measures the time it takes to convert a company's cash from one form into another. The CCC is important because it's a key indicator of how well a company manages its finances. A higher CCC means more efficient working capital management, which can improve profitability and return on equity.

Working capital is a business's money available to pay its short-term bills. It's also known as current assets or current assets minus current liabilities. Return on equity (ROE) measures how profitable a company is relative to the money that shareholders have invested in it. Cash conversion cycle evaluations consider the following components:

Days inventory outstanding (DIO)

Days inventory outstanding is an essential part of CCC calculations. It measures how long it would take to turn all of a company's inventory into cash. The purpose of DIO is to provide a quick way to assess how efficiently a company collects its receivables or how quickly customers pay their bills.

DIO can show you how well a company manages its inventory levels. It can also help you identify areas that need improvements for profitability and efficiency. You can calculate DIO by dividing the average inventory by the total cost of items sold and multiplying the result by 365 days.

Days sales outstanding (DSO)

Days sales outstanding is a metric that measures the average number of days between when a customer pays for an order and the date the business receives payment. It shows how long a customer takes to pay for their purchase.

DSO is important because it tells how quickly a business can convert sales into cash. A higher days sales outstanding could indicate that customers take longer to pay their bills.

Related: 22 Finance Department KPIs You Can Track To Support a Company

Days payable outstanding (DPO)

Days payable outstanding is the average time a company takes to pay its suppliers for goods and services. You can get this figure by dividing the number of accounts receivable by the average net sales per day.

A high DPO may signify that a company takes longer to pay its bills. This metric can help assess whether a company is collecting sales invoices on time and whether there are enough days of credit extended to customers.

Related: Guide to Cash Flow

Why is the cash conversion cycle important?

Analysts use the cash cycle conversion to evaluate a company's efficiency in managing its accounts receivable and inventory levels. It helps determine how well a company can provide goods or services and collect payment without holding too much inventory or extending credit for too long. A company with a long cycle might want to replenish its inventory before customers run out of stock. This may help prevent missed sales opportunities because customers can't find what they're looking for in stores or online.

The other benefit of CCC is that it provides a more accurate understanding of a business's financial health than simply looking at net income or other gross metrics. It also allows you to compare a business with others that have similar sales volumes and expenses.

Related: What Is Inventory Turnover?

Who measures the cash conversion cycle?

Companies use the cash conversion cycle to evaluate how well they manage their cash flow. This assessment helps ensure enough capital is available for unexpected expenses or opportunities, such as new product launches or acquisitions of other firms. Managers can also use this metric to track how inventory levels change the overall efficiency of business operations.

Investors use the cash conversion cycle to determine how efficiently a company uses its capital. If a company has a shorter cash conversion cycle than its competitors, it may be able to invest more money into its operations or spend more on marketing because it can get paid back faster from sales.

Related: 6 Essential Accounting Skills

When to evaluate the cash conversion cycle

Most companies record daily cash flow activities. For example, they record sales when they ship products and receive cash. They record purchases when customers place their orders and record accounts payable when they pay the money they owe to creditors. These daily activities give them an understanding of their CCC at any time during the year.

Businesses typically evaluate cash conversion cycles quarterly or annually. Evaluating CCC often requires analyzing multiple months' worth of transactions, which may involve complex calculations with numerous currencies. By looking at various months collectively, you can better understand how efficiently the company converts sales into cash over time than you could by looking at one month in isolation.

Related: What Is Inventory Management? Definition and Techniques

How to calculate the cash conversion cycle

CCC calculations track how well a company's cash management practices optimize its overall cash flows. Here's how to calculate the cash conversion cycle:

1. Determine the days inventory outstanding

To find your DIO, use the below formula:

DIO = (average inventory / cost of goods sold) x 365

The average inventory is the sum of the period's beginning and ending inventory divided by two. Financial documents and balance sheets can be great sources for the costs of goods sold and the amounts.

Related: Learn About Being an Accounts Receivable Specialist

2. Determine days sales outstanding

To find your DSO, use the below formula:

DSO = (average accounts receivable / cost of goods sold) x 365

You can find the total cost of goods sold on the balance sheet. Calculate the average accounts receivable by summing up the beginning and ending accounts of the period and dividing the result by two.

Related: Days Outstanding Sales: What It Is and How To Calculate It

3. Determine days payable outstanding

To calculate DPO, use the below formula:

DPO = (average accounts payable / costs of goods sold) x 365

You can calculate average accounts payable by summing up the accounts payable figures at the beginning and end of the period and dividing the result by two.

Related: Days Payable Outstanding (DPO) Calculation (With Steps)

4. Calculate the total cash conversion cycle

Add the DIO and DSO and subtract the DPO to find the cash cycle evaluation. The answer is in the number of days. If it has a decimal point, round it to the nearest whole number. You can use the formula below to determine the cash conversion cycle:

Cash cycle conversion = DIO + DSO − DPO

Related: Learn About Being an Accountant

Cash cycle conversion example

Here's an example of calculating a cash cycle conversion:

In the first quarter of 2022, AJPR and Company's inventory averaged $100,000, and the total cost of goods sold was about $600,000. The company's total cost of goods sold was $180,000, and the average accounts receivable was $30,000, with a total credit sales of $400,000. The average accounts payable was $50,000.

To calculate its CCC, the company starts by finding the days inventory outstanding:

DIO = (100,000 / 600,000) x 365 = 60.83

Then, the company calculates its DSO from its average accounts receivable of $30,000 and the total credit sales of $180,000:

DSO = (30,000 / 180,000) x 365 = 60.83

The next step is to calculate the DPO. The company uses its average accounts payable, which is $50,000, and the cost of goods sold on credit, which is $400,000:

DPO = (50,000 / 400,000) x 365 = 45.63

To find its cash conversion cycle, AJPR completes the following calculation:

CCC = 60.83 + 60.83 − 45.63 = 76.03 days

This indicates that the company takes an average of 76 days to convert its inventory into cash.

Explore more articles