date: 2021-06-14 11:39:33

The cash conversion cycle (CCC) measures how long it would take a company to convert its inventory to cash. It lets you figure out how long it takes you to sell inventory, how long it takes you to collect on accounts receivable, and how soon you have to pay your accounts payable.

For example, if a company purchases supplies and pays the supplier 30 days after the purchase is made (that is called Days payables outstanding), then-after, the supplies stays in the inventory for 50 days before it is sold to a customer/client (Days inventory on hand) who then pays the company in 40 days (Days sales outstanding), in that sense the cash conversion cycle would be 60 days (40+50-30 days).

Putting the above example in a formula, CCC is equal to:

Days inventory on hand (DIO) + Days sales outstanding (DSO) – Days payables outstanding (DPO).

The shorter your company’s cash conversion cycle is, the better. If your CCC is low or even negative, that means your working capital isn’t tied up for long, and your business has greater liquidity. 

Many online retailers have low or even negative CCC’s because they drop ship instead of maintain inventory, get paid right away when customers buy products, and don’t have to pay for the inventory until customers have already paid them.

Various solo businesses are concepted based on selling goods that don’t actually need any upfront cash to begin with. For example, let us say you know how to paint and fix broken chairs, you go to a supplier who sells broken chairs for 5 USD$ each with a 60-day credit, you then take that chair fix and paint it, which takes around 20 days. That costs you another 5 USD$. You then go sell the chair via an online retailer for 12 USD$, which in average takes around 30 days to sell. That means that in total your cash conversion cycle was negative ten days (20 days + 30 days – 60 days). That also means that you profited 2 USD$ per chair, without actually paying any cash upfront and you have the privilege of carrying 12 USD$ for two days. In large businesses that equates to extra revenue via a daily interest paying time deposit at a bank.

Now what happens if your CCC is actually positive (like 90%+ of the businesses worldwide). A positive CCC reflects how many days your business’s working capital (the finance terminology) is tied up while you’re waiting for your accounts receivable to be paid. You may have a high CCC if you pay your suppliers in cash and sell products on credit with customers that typically take 30, 60 or even 90 days to pay you.

Importance of the cash conversion cycle

Monitoring your cash conversion cycle is important for various reasons:

• Supplies operating in various industries usually understand the sector well. That means that for certain industries, suppliers understand that a specific sector’s CCC is large for big players, which effectively means that they don’t do business with small players in fear of their business lacking liquidity.
• CCC is critical to understand whether you will need to borrow a short term loan from a bank at any given time, hence, incorporating the expected interest expenses in your financial budget / valuation.
• Investors and shareholders will assess a company’s CCC in order determine the financial health of a company, along with other financial metrics. The more liquid a company is, the more easily it can pay back a business loan, meet its other financial obligations and invest in growth.
• CCC is also vital for internal purposes. A low CCC indicates that you are operating efficiently, however, if you have high CCC, it is critical to try to extend your credit terms with your suppliers, become more aggressive with collecting your receivables and efficiently manage our inventory. Sometimes a high CCC indicates that there is lack of demand in your product, operational issues or declining market.

In summary, if you have a high CCC try to figure out methods to decrease it as much as you can. On the other hand, if you have a negative CCC, try to take use of it as much as possible.

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