The cash conversion cycle (CCC) is the length of time, averaged in terms of days, which it takes for a company to convert expenditure on raw materials and other production costs into receipts of cash through the sale of its goods and services. It offers an indication of a business’s operational efficiency and liquidity.
A fundamental measurement of working capital management, the cash conversion cycle can vary across companies and industries. It is a popular indicator, used widely in corporate finance and investment analysis, which shows how long it takes a firm to convert production activities (requiring cash) back into cash.
The shorter a company’s CCC, the less cash is tied up in working capital. This also means the company will be less reliant on external funding. A positive value for the CCC indicates the company is perhaps borrowing while it awaits payment. Companies ideally aim for a low or even negative CCC. The latter situation arises when the company receives cash receipts before it is due to make any payments. Amazon is one company that operates a negative CCC.
A function of three distinct variables, CCC can be calculated as follows:
\(\mathrm{CCC}={\mathrm{Days\: Inventory\: Outstanding\: DIO}\:+\:\mathrm{Days\: Sales \:Outstanding\: DSO}\:–\:\mathrm{Days\: Payable\: Outstanding\:DPO}}\)
Days Inventory Outstanding (DIO), also known as the average ‘stockholding period’, is the length of time it takes for a company to convert cash spent on production to cash receipts garnered at the point of sale. It in effect tells the company how often its stock turns over in a given amount of time. But it varies across industries.
Days Sales Outstanding (DSO) measures how long it takes, on average, for a company to collect revenue after a sale is made. The quicker receivables are collected, the sooner the company can set about reinvesting cash into the business. A lower DSO, therefore, would imply less reliance on external funding, and places the company in a comfortable working capital position. A high DSO usually implies that goods are sold on extended credit. In this sense, the value of the DSO will be dependent on forces beyond the company’s control (ie, the conduct of customers).
Finally, Days Payable Outstanding (DPO) is the number of days a company has before it has to make payments to creditors. The higher DPO is, the longer the company has to accumulate cash receipts before repaying its financial obligations. Taking these three variables into account, the CCC can also be written as:
\(\mathrm{CCC}={\mathrm{\frac{Inventory}{Cost\: of \:sales}}\times\mathrm{365}}\:+\:{\mathrm{\frac{Accounts\: receivable}{Total\: credit\: sales}}\times{365}}\:–\:{\mathrm{\frac{Accounts\: payable}{Cost\: of \:sales}}\times{365}}\)
*where 365 refers to the number of days in the period.
A worked example
In this example, the company has a negative CCC:
\(\mathrm{DIO}={\mathrm{72.5\:,\:DSO}={\mathrm{38.3\:,\:DPO}}={\mathrm{140}}}\)
\(\mathrm{CCC}={\mathrm{72.5\:+\:\mathrm38.3\:–\:\mathrm140}}={\mathrm–\:29.2}\)
This means that, after a company receives its cash receipts, it has over 29 days to pay its suppliers for raw materials and other production costs.
Points to consider
The CCC measures the length of time from the outlay of cash for stock to the recovery of cash after the sale. But it is important to note that the CCC is also a dynamic measurement. It incorporates the condition of time. It can therefore offer a better indication of a company’s liquidity than, say, the current ratio, which is a static measurement.
Also, the CCC should be viewed in the context of a trend. When it grows in size, it represents a negative development for the business (for example, cash becomes tied up in production for longer). On the other hand, when the CCC is reduced, it suggests that the business may be managing its liquidity more effectively. Academic studies have suggested that, the larger the company, the more likely it will have a shorter CCC. In addition, it has been found there is a statistically significant negative correlation between CCC and profitability.
