Cash Conversion Cycle

The Cash Conversion Cycle or Net Operating Cycle tells us how long a company takes to raise cash from inventory sales. Often, instead of paying in cash, a company finances its inventory. That means you owe money to someone who generates "payable accounts." Mostly they turn around and sell the credit product without earning all the money on the day of sale. 

CCC (Cash Conversion Cycle) tries to measure how long each net input rupee is tied up in the production and sales process before it converts into cash received. This measure takes into account how much time the company needs to sell its inventory, how much time it takes to collect its debts, and how much time it needs to pay its bills without incurring penalties. 

The Cash Cycle has Three Separate Parts: 

The first part of the process is the current level of inventory and how long it will take for the company to sell this inventory. Calculation of the outstanding inventory days helps us to evaluate stage one. 

The second stage of the cash cycle is the current sales and the amount of time it takes to collect cash from the respective sales. The calculation of outstanding sales days helps to evaluate stage two. 

The third stage is the current due accounts payable. In other words, this represents how much the company owes to its current vendors for inventories and purchases of goods and when the company will have to pay off its vendors. Days payable outstanding calculation helps in validating stage three. 

Stage Wise Formula Explanation:

  • DIO (Days Inventory Outstanding), commonly known as DSI, is calculated using the cost of goods sold (COGS), which is the cost of manufacturing the products sold by a company over some time. Mathematically explaining,
    DIO = (Average Inventory ÷ Cost of Goods Sold) x 365
    Average inventory = (Beginning Inventory + Ending inventory) ÷ 2
    COGS = Beginning Inventory + Purchases - Ending Inventory
  • A lower value for DSO is a desirable outcome, which indicates that the company is in a position to collect capital in a short period and increases its cash position.
    DSO = (Accounts Receivable ÷ Net Credit Sales) x 365
    Accounts Receivable = (Beginning Receivables + Ending Receivables) ÷ 2
  • It is calculated through the use of the Days Payables Outstanding (DPO), which takes account payable into account. A higher value of DPO is preferred. By maximizing this amount, the company is holding on to cash longer, increasing its investment potential.
    DPO = Ending Accounts Payable ÷ (Cost of Goods Sold ÷ 365)
    Accounts Payable = (Beginning Payable + Ending Payable) ÷ 2

The Cash Conversion Cycle is Calculated By:

CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO)  

The shorter the CCC for a business, the better it is for the operations. If the CCC for a business is small or better considered as unfavorable, this means the working capital for the business is not engaged in any activity and is thoroughly available, leaving a high amount of liquidity. Many online retailers today in the market have a low or negative CCC as they do not have an inventory and get paid directly after the consumer purchases the product, they do not even have to pay for the inventory till the consumer pays the complete amount. If the CCC of any business is positive, it's feasible for the business but not too high positive numbers. 

This positive number reflects the amount of working capital tied up for the business while waiting for the accounts receivable to be settled. For example, credit businesses have a high CCC as the consumers have a credit period of either 15, 30, 60, or even 90 days depending on the credibility. This ratio explains how much time it takes for a company after it has invested a hefty load in inventory to receive payments from customers. 

The cash is not paid immediately when the inventory is purchased. This means that the acquisition is carried out with credit, which allows the company to market its inventory to customers. The company makes sales during this time but does not yet receive the cash. Then comes the day when the company has to pay for the earlier purchase. And after a while, the company gets the cash on the due date from its customers.

Importance for Cash Conversion Cycle:

  • Investors, lenders, and other funding sources often evaluate the cash conversion cycle of a company to determine its financial health and liquidity, in particular. The more liquid a company is, the easier it can repay the loan, fulfill its other financial commitments, and invest in growth. The cash conversion cycle is most helpful for evaluating inventory-based companies, for example, retailers. It is not the only financial criteria used by funding sources to determine financial health, but they use it with different other techniques and evaluate.
  • Suppliers and creditors always look at CCC to determine whether to extend the credit period or not. As, if the business lacks an adequate amount of liquidity, the suppliers and creditors are often exposed to default and credit risk. This tool not only helps the suppliers but the creditors also to evaluate the credibility of the business to lend a sum of money.

No matter how strong your company's sales and revenues are, it takes cash to keep your business going. An improvement in your currency conversion cycle is one of the best ways to boost cash flow. To decide whether you have sufficient liquid capital to continue operations and to run your business cycle, it is necessary to measure a period for your cash conversion to minimize the need for external funding or to raise more equity capital. 

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