The cash conversion cycle (CCC) is a metric that indicates the time (measured in days) it takes a company to convert its investment in inventory into cash flows from sales. The CCC, also referred as the “cash cycle,” attempts to measure how long each net input euro is tied up in the production and sales process before it is converted into a cash receipt.
The CCC is one of several quantitative measures that can be used to evaluate the efficiency of a company’s operations and management. A trend of decreasing or consistent CCC values over multiple time periods is a good sign, while increasing values should lead to further investigation and analysis based on other factors. It should be remembered that the CCC value applies only to selected sectors that depend on inventory management and related operations.
Calculation of the CCC
The cash conversion cycle of a company essentially goes through three different phases. To calculate the CCC, you need several items from the financial statements:
- Sales revenue and cost of goods sold (COGS) from the income statement
- Inventories at beginning and end of period
- Trade receivables (AR) at beginning and end of period
- Trade accounts payable (AP) at beginning and end of period
- The number of days in the period (e.g. year = 365 days, quarter = 90).
The first level focuses on existing inventory and indicates how long it will take for the company to sell its inventory. This figure is calculated using Days Inventory Outstanding (DIO). A lower value of DIO is preferable because it indicates that the company is selling quickly, which means better sales.
DIO, also known as DSI, is calculated based on the cost of goods sold, which is the cost of acquiring or producing the products that a company sells in a given period.
The second level focuses on current sales and indicates how long it takes to receive the funds generated from sales. This figure is calculated using the days sales outstanding (DSO), by dividing the average outstanding balance by the sales per day. A low DSO value is preferred as it indicates that the company is able to collect capital in a short period of time, which in turn improves its liquidity.
The third stage focuses on the company’s current liabilities. It takes into account the amount of money owed by the company to its current suppliers for the purchased inventories and goods and represents the period of time in which the company has to settle these obligations. This figure is calculated using Days Payables Outstanding (DPO), which takes into account trade payables. A higher DPO value is preferable. By maximizing this figure, the company holds cash for longer, which increases its investment potential.
What the cash conversion cycle can tell you
The CCC tracks the life cycle of cash used for operations. It tracks how cash is converted first to inventory and payables, then to product or service development expenses, to sales and receivables, and finally back to cash. Essentially, the CCC indicates how quickly a company can convert the cash it invests from start (investment) to finish (return). The lower the CCC, the better.
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