Cash Conversion Cycle (Operating Cycle)
The cash conversion cycle (CCC, or operating cycle) is the time between a company's purchase of inventory and the receipt of cash from accounts receivable. It is the time it takes for a company to convert purchases into cash receipts from customers. CCC represents the number of days that a company's cash is tied up in its operations. It reflects the amount of time between when a company pays for raw materials and when it receives payment for the finished goods produced using those materials. A cash flow analysis using CCC also provides an overall picture of how efficiently the company is managing its working capital.
The cash conversion cycle is also referred to as the cash cycle, asset conversion cycle or net operating cycle.
Cash Conversion Cycle Formula
The cycle is composed of three main working capital components: Days Inventory Outstanding (DIO), Days sales outstanding (DSO) and Days Payable Outstanding (DPO). The Cash Conversion Cycle (CCC) is equal to the time is takes to sell inventory and collect receivables less the time it takes to pay the company's payables:
Cash Conversion Cycle (CCC) = DIO + DSO – DPO
Inventory days refer to the average number of days it takes a company to sell its inventory, which is calculated as the average inventory divided by the cost of sales per day. Accounts receivable days (days sales outstanding) refer to the average number of days it takes a company to collect payments from its customers, which is calculated as the average accounts receivable balance divided by the sales per day. Accounts payable days refer to the average number of days it takes a company to pay its suppliers, which is calculated as the average accounts payable balance divided by the cost of sales per day. The CCC is then calculated as the sum of inventory days and accounts receivable days minus accounts payable days.
The use of the CCC is mainly to evaluate the efficiency of a company's working capital management. A negative CCC indicates that a company can convert its resources into cash more quickly than it pays its bills, which is a good sign for the company's liquidity. On the other hand, a positive CCC means that a company is taking longer to convert its investments into cash, which may be a sign of inefficiencies in its operations or working capital management.
Cash Conversion Cycle Standard
There is no one "standard" cash conversion cycle that applies to all companies. The optimal CCC varies by industry and can also depend on other factors, such as a company's size, financial position, and business strategy.
A lower CCC is generally preferred since it shows that a corporation manages working capital more effectively. The definition of a "good" or "poor" CCC, however, varies considerably according on the business. In contrast to those that deal with perishable commodities, like construction, perishable goods-related businesses, such the food industry, often have relatively shorter CCCs. This is so that perishable commodities may be sold and turned into cash more rapidly as they have a shorter shelf life.
A negative CCC might occasionally be advantageous as it shows that a business is able to raise cash from clients and pay its obligations quicker than it needs to invest in inventory. A negative CCC, however, might also mean that a business is extending its accounts payable or postponing payments to suppliers in order to have a positive cash flow, both of which can have unfavorable long-term effects.
The best CCC for a firm will ultimately rely on a number of variables, including its industry, size, and financial situation. A firm may learn a lot about how effective its working capital management is by examining the CCC and comparing it to industry standards and rivals, as well as identifying areas for improvement.
A short cycle allows a business to quickly acquire cash that can be used for additional purchases or debt repayment. The lower the cash conversion cycle, the more healthy a company generally is. Businesses attempt to shorten the cash conversion cycle by speeding up payments from customers and slowing down payments to suppliers. CCC can even be negative; for instance, if the company has a strong market position and can dictate purchasing terms to suppliers (i.e. can postpone its payments).
The analysis of the CCC can also be compared to industry benchmarks to see how well the company is performing compared to its peers. This analysis may involve comparing the CCC to the industry average or to competitors in the same market.
Example of CCC calculation
Here's an example of how to calculate the cash conversion cycle (CCC) for a hypothetical company:
Let's assume that the company has the following financial data for the most recent fiscal year:
- Days sales outstanding (DSO) = 45 days
- Days inventory outstanding (DIO) = 30 days
- Days payable outstanding (DPO) = 60 days
To calculate the CCC, we can use the following formula:
CCC = DSO + DIO - DPO
Substituting the values for DSO, DIO, and DPO from our example, we get:
CCC = 45 + 30 - 60 = 15 days
So in this example, the company has a cash conversion cycle of 15 days. This means that on average, it takes the company 15 days to convert its investments in inventory and accounts receivable into cash, after taking into account the time it takes to pay its suppliers.
Remember that this is only an illustrative example and that the ideal CCC will vary based on the sector and other elements. However, a business may get important insights into its working capital management and spot areas for improvement by computing the CCC and tracking it over time.
CCC for Financial Institutions
The calculation and interpretation of the cash conversion cycle can be different for financial institutions compared to non-financial businesses.
In general, financial institutions such as banks and insurance companies have a shorter CCC compared to non-financial businesses. This is because the core business of financial institutions involves taking in deposits or premiums, investing those funds, and earning a return on those investments. As a result, financial institutions have a significant portion of their assets invested in short-term securities such as Treasury bills or commercial paper, which have a maturity of less than one year.
Therefore, the CCC for financial institutions can be calculated using a modified formula that accounts for the specific nature of their operations. The formula for financial institutions can be written as:
CCC = (Average receivables + Average inventory) / Average daily sales
In this case, "average receivables" refers to the average balance of customer deposits, loans, and other receivables, while "average inventory" refers to the average balance of short-term securities and other investments. "Average daily sales" can be calculated as the total interest, dividends, and other income earned over the period divided by the number of days in the period.
It's important to note that the CCC is just one of many financial ratios used to analyze the performance of financial institutions. Other factors such as interest rate risk, credit risk, and capital adequacy are also important considerations for investors and regulators.
How to Improve the Cash Conversion Cycle?
There are several ways that a company can improve its cash conversion cycle:
- Streamline inventory management: One of the most effective ways to improve the CCC is to optimize inventory management. This can involve implementing just-in-time (JIT) inventory systems, reducing the amount of safety stock held, and improving forecasting and demand planning to avoid overstocking.
- Improve accounts receivable processes: A company can improve its CCC by reducing the amount of time it takes to collect payment from customers. This can involve establishing clear payment terms and policies, following up promptly on late payments, and offering incentives for early payment.
- Optimize accounts payable processes: A company can also improve its CCC by extending payment terms with suppliers without damaging relationships or jeopardizing credit ratings. This can involve negotiating favorable payment terms with suppliers, improving purchase order processes, and taking advantage of early payment discounts.
- Reduce production and order fulfillment times: By reducing the time it takes to produce and fulfill orders, a company can improve its CCC. This can involve improving manufacturing processes, reducing lead times, and optimizing supply chain management.
- Improve cash flow forecasting: A company can improve its CCC by developing accurate cash flow forecasting models that take into account factors such as seasonality, market trends, and changes in working capital requirements.
By focusing on these areas, a company can improve its CCC and optimize its working capital management. This can lead to increased liquidity, improved profitability, and a more sustainable business model in the long run.