What’s it: The cash conversion cycle measures how long, in days, it took a company to collect cash since the money was spent on buying raw materials. The shorter the cycle, the faster the company generates cash from its investment in selling inventory. And, it is preferable.
How does the cash conversion cycle work?
Companies go through a series of processes to make money. First, they invest money to buy inventory, say on credit. They receive input from suppliers but do not pay until the financial statements are prepared. Thus, it is an obligation, and they must settle it in the future. Finally, they report the amount payable as trade payables in the current liabilities section.
Companies then sell their inventory. Some are sold for cash. Others are sold on credit.
Because they sell on credit, they have not received cash even though they have delivered their products to customers. As a result, they report it as an account receivable in current assets and collect the cash from customers.
They then use the proceeds from the sale to pay suppliers. Others are reinvested in working capital, short-term investment, or fixed assets.
How long it takes the company to go through the process, that’s the cash conversion cycle. This metric measures how many days to sell its inventory, how many days to collect receivables from customers, and how many days to pay its invoices to suppliers.
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Why is the cash conversion cycle important for a business?
The cash conversion cycle is important for evaluating how efficient management generates more cash from business operations. As the cycle gets shorter, the company can collect cash more quickly. And therefore, the company’s financial liquidity is also getting better.
If the cycle is relatively stable or declining, that is a good sign. Conversely, if it continues to rise over time, it requires further investigation of the cause.
For example, a longer cycle might result from slower inventory turnover, so more time to sell the product. This may be due to declining product competitiveness, competitors being more aggressive in marketing or deteriorating economic conditions.
In other cases, the company may sell more products to customers with poor credit quality. So, they pay bills longer.
How to calculate the cash conversion cycle?
Calculating the cash conversion cycle requires using other financial ratios as input. They are:
- Days of inventory on hand (DIH)
- Days sales outstanding (DSO)
- Days payable outstanding (DPO)
All three, in particular, highlight the time between spending money on supplies and collecting cash from customers. First, companies convert their cash on hand into inventory. Then, they sell the product to customers, collect payments from customers and pay suppliers.
After obtaining all three ratios, we calculate the cash conversion cycle by adding DIH to DSO and subtracting the result from DPO. Here’s the formula:
- Cash conversion cycle = DIH + DSO – DPO
Let’s dissect the three components to calculate the cash conversion cycle.
Three components of the cash conversion cycle
Days sales outstanding (DSO) shows the time it takes to collect payments from customers. It is inversely proportional to the accounts receivable turnover. The higher the receivables turnover, the faster the company collects payments. To calculate it, we divide the number of days in a year (365 days) by the accounts receivable turnover.
- DSO = 365 / Accounts receivable turnover
- DSO = (Average accounts receivable * 365) / Revenue
Then, days of inventory on hand (DIH) tell us how many days, on average, the company converts inventory into sales. We calculate it by dividing the number of days in a year by the inventory turnover. Because it is inversely related to DIH, high inventory turnover means fewer days it takes the company to sell its inventory.
- DIH = 365 / Inventory turnover
- DIH = (Average inventory * 365) / Cost of goods sold (COGS)
Finally, days payable outstanding (DPO) measures how many days the company pays its suppliers on average. We calculate it by dividing the number of days in a year by the accounts payable turnover. Here’s the mathematical formula:
- DPO = 365 / Accounts payable turnover
- DPO = (Average accounts payable * 365) / Purchases
Accounts for the above ratio calculations can be found in the income statement and balance sheet. The exception is the purchase. We calculate it manually by subtracting ending inventory from beginning inventory and adding up the result by the cost of goods sold.
- Purchases = Ending inventory – Beginning inventory + Cost of goods sold
How to interpret the cash conversion cycle?
Because the cash conversion cycle measures how long it takes to generate cash from each investment in inventory, the shorter the cycle, the better. This situation indicates better liquidity as the company can quickly generate cash, which can be used further to support working capital, internal capital for long-term investments, or pay liabilities. And, with cash accumulating faster, companies are less likely to depend on external financing to support working capital.
On the other hand, longer cycles are less desirable because the company needs more days to make money. As a result, companies tend to be poor in liquidity.
What are the factors affecting the cash conversion cycle?
Several factors affect the cash conversion cycle. For example, the efficiency of operations, production techniques, and the supply chain length affect the speed with which a company can obtain inventory, convert it into finished products, and sell it to the market.
Marketing strategy and credit and collection policies also affect cycle length. For example, strict credit policies make it faster for companies to collect payments from customers. In other cases, companies offer discounts for early payments, encouraging customers to pay faster.
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