Cash Conversion Cycle: Explained
The cash conversion cycle estimates the time is takes for cash to flow through a company. Sales are the beating heart of any business, but the sales process is complex.
What Is The Cash Conversion Cycle?
The journey from raw material to cash on the income statement is long with many variables. The cash conversion cycle (CCC) measures the amount of time in days it takes for those input materials to turn into cash on hand. Also, it measures the overall health of a company in addition to its efficiency. Management uses this metric in evaluating its strengths and weaknesses in places like sales teams, or the supply chain.
Furthermore, the cash conversion cycle = DIO + DSO – DPO
DIO = days inventory outstanding
DSO = days sales outstanding
DPO = days payable outstanding
Intuitively, the CCC evaluates the time it takes to sell inventory, collect receivables, and pay its bills. DIO is the number of days it takes to sell an entire inventory. The lower the better in this regards. DSO calculates the number of days to collect on accounts receivable. DPO calculates the amount of time the company takes to pay its own bills. Conversely to the first two numbers, a longer DPO is preferred as it allows the company to hold onto cash longer.
Analyzing the Cash Conversion Cycle
Large scale business is not typically done on a cash basis. For example, a company buys inventory on credit, and sells on credit. This results in accounts payable and accounts receivable credits and debits, respectively. Additionally, this strategy focuses on the sale and worries about the actually payments later. This structure only works if both the parties have reputable credit history.
Lastly, the cash conversion cycle is an excellent indicator of management’s efficiency. Measures within industries, the CCC tells how cash strapped a company will be if they decide to invest heavily in the future for higher sales.
The cash conversion cycle is a transparent way to analyze companies operating efficiency. Companies that turn sales into cash sooner dominate the market and become market leaders. These leaders eventually either buy out or push weaker companies out of the space, increasing their own worth.