For small businesses, cash flow is one of the most important determinants of business success. There are many metrics used to monitor cash flow, one of which is the Cash Conversion Cycle (CCC).
The CCC measures a company’s effectiveness at converting its investment in inventory into cash. The cycle typically involves purchasing inventory inputs on credit (Accounts Payable), selling the inventory through sales on credit (Accounts Receivable), and converting inventory back into cash. The lower the number of days in the CCC, the more effective management is at generating cash flow from the sale of its product or service.
How the Cash Conversion Cycle Is Calculated
The formula is comprised of three figures.
• Number of “days inventory on hand” (DIO)
• Number of “days sales outstanding” (see article on DSO here)
• Number of “days payable outstanding” (DPO)
The formula for calculating the Cash Conversion Cycle (CCC) is:
CCC = DIO + DSO – DPO
DIO, DSO and DPO represent the three component stages of the conversion cycle. For a service company the cycle would only include the DSO and the DPO metrics.
Lets look at each stage of the CCC to understand the relationships.
- The DIO stage measures the time (in days) required to turn over one complete inventory. DIO can be calculated using figures taken from the annual financial statements; Inventory from the balance sheet and Cost of Sales from the income statement. It is calculated as:
DIO = Inventory /Cost of Sales x 365The idea is to minimize the DIO by turning over inventory as quickly as possible. Selling inventory converts the owner’s investment in inventory into Accounts Receivable, or directly into Cash in the case of cash sales at a retail store. - The DSO stage measures the number of days needed to collect the Accounts Receivable. Using the Accounts Receivable figure from the year-end balance sheet and the Net Credit Sales from the annual Income Statement, it is calculated as:
DSO = Accounts Receivable/Net Credit Sales x 365Like DIO, a business owner wants to minimize DSO. DSO measures how quickly the business is able to convert a credit sale into cash. - The DPO stage measures the number of days it takes to pay vendors for the inventory purchased or expenses incurred to deliver your product or services. Using the Accounts Payable figure from the year-end balance sheet and the Cost of Sales from the Annual Income statement, it is calculated as:
DPO = Accounts Payable/Cost of Sales x 365In contrast to the DIO and DSO stages, business owners want to maximize DPO. A business improves its cash position by holding onto cash longer. Cash flow benefits, of course, must be carefully measured against a company’s payment terms with vendors. Its important to maintain good relationships with your vendors because they help you grow your business.
The Cash Conversion Cycle metric is most useful in comparing a company’s cash flow performance this year against the performance in previous years, or against competitors’ performance. By monitoring the trends of the CCC metric, you can spot potential cash flow issues before they become a crisis.