Cash Conversion Cycle - Explained
What is the Cash Conversion Cycle?
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Table of ContentsWhat is the Cash Conversion Cycle?How does the Cash Conversion Cycle Work?Research Article for Cash Conversion Cycle (CCC)
What is the Cash Conversion Cycle?
A Cash Conversion Cycle (CCC) is a cash flow calculation that measures the number of days that it takes for a company to realize cash flows from sales after the conversion of its investments in inventory and other resources. It is a metric that measures the time frame in which cash is tied up in production and sales process before it is converted to cash flows from sales. This cash conversion cycle formula or metric also takes into account the amount of liquidity risk entailed in the production and sales process, the amount of time needed by a company to sell inventory, collect receivables and pay off its bills.
How does the Cash Conversion Cycle Work?
In general, businesses make more profits when more goods are produced and put up for sale. Companies put out more products for sales to make more profits. Accounts payable (AP) and accounts receivable (AR) are terms commonly used in businesses. AP can be derived when companies acquire inventory on credit (debt). Timing is a determinant of when a company pays AP and collects AR, this is why CCC is a metric that measures the length of time needed for a company's activities (production and sales) before cash is realized. CCC follows how cash is changed into inventory through AP, then converted into expenses for production and sales before it is now converted into cash flows or cash at hand through the sales of goods to customers. Three business stages are involved in the calculation of the cash conversion cycle of a company. The first stage measures the level of the existing inventory of a company and the amount of time required to sell the inventory. To arrive at this figure, the Days Inventory Outstanding (DIO) is calculated.
The formula for this calculation is;
DIO = Average Inventory/COGS per day
where, Average Inventory = (Beginning Inventory + Ending Inventory)/2
A lower value of DIO is an indication that a company is making rapid sales. The second stage uses Days Sales Outstanding (DSO) to measure the current sales and the amount of time needed to collect all account receivables generated from the sale. When the DSO is low, that means a company collects cash within a short space.
The formula for calculating DSO is;
DSO = Average AR / Revenue per day
where, Average AR = (Beginning AR + Ending AR)/2.
The third stage uses the Days Payables Outstanding (DPO) to measure the amount a company owes and the required time to pay off the debts. A higher DPO means a company pays its obligations in due time.
The formula is; DPO = Average AP/COGS per day where, Average AP = (Beginning AP + Ending AP)/2.