As a small business owner, managing your finances is vital to ensure your company’s success. This could include keeping track of inventory levels, receivables and payables to identify potential issues before they become major problems. One way to monitor these trends is by using the cash conversion cycle.
The cash conversion cycle is a metric used to measure the time it takes for a business to convert its investments in inventory and other resources into cash flow. It is a critical tool for small business owners to understand because it can help identify where cash flow issues may arise. By tracking the cash conversion cycle, you can see how long it takes for your business to convert its investments into cash, which can help you make better decisions about when to invest in new inventory or equipment.
To calculate the cash conversion cycle, you need to take into account the length of time it takes for your business to sell its inventory, the length of time it takes for your customers to pay their invoices, and the length of time it takes for you to pay your suppliers. You can determine the net cash conversion cycle by subtracting the time it takes for you to pay your suppliers from the time it takes for your customers to pay their invoices. This figure represents the amount of time it takes for your business to convert its investments into cash flow.
What Is The Cash Conversion Cycle?
The cash conversion cycle (CCC) is a metric that reflects the amount of time it takes for a company to convert inventory or materials the company purchases to cash.
It’s calculated using this formula:
- CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) + Days Payable Outstanding (DPO)
Working Capital Metrics
Days Inventory Outstanding (DIO)
This metric measures the average number of days a company has inventory on hand before it’s sold to a customer. Here’s the calculation:
- DIO = (Average Inventory / Cost of Goods Sold) * 365
For example, assume your company had $900 worth of inventory at the beginning of the year and $2,100 at the end of the year with a cost of goods sold of $28,000. The DIO calculation would be as follows:
- Average Inventory = $1,500 or ($900 + $2,100) / 2
- Cost of Goods Sold = $28,000
- DIO = 19.55 or ($1,500 / $28000) * 365
So, it takes your company around 19 days to move inventory.
Days Sales Outstanding (DSO)
This metric measures the amount of time to collect receivables. The formula is as follows:
- DSO = (Average Accounts Receivable / Total Credit Sales) * 365
To illustrate, if your company started the year with $1,500 in receivables, ended it with $8,000 and had total credit sales of $80,000, here’s how you’d calculate the DSO:
- Average Accounts Receivable: $4,750 or ($1,500 + $8,000) /2
- Total Credit Sales: $80,000
- DSO: 21.67 or ($4,750 / $80,000) * 365
Based on the calculation, it takes your customers 21 days on average to pay their invoices.
Days Payable Outstanding (DPO)
This metric measures the number of days, on average, it takes your company to pay outstanding invoices, also known as payables. Here’s the formula:
- DPO = (Average Accounts Payable / Cost of Goods Sold) * 365
For example, if your company had $1,000 in payables to start the year, ended with $1,500, and the cost of goods sold was $36,000, here’s how you’d determine the DSO:
- Average Accounts Payable: $1,250 or ($1,000 + $1,500) / 2
- Cost of Goods Sold: $28,000
- DPO: 15.85 or ($3,000 / $28,000) * 365
As evidenced in the calculation above, it takes your company 15 days to pay its invoices.
Cash Conversion Cycle Formula
Earlier in this guide, you learned that the cash conversion cycle formula is as follows:
- CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) + Days Payable Outstanding (DPO)
Based on the examples above, your company’s CCC would be 25.37 (19.55 for DIO + 21.67 for DSO – 15.85 for DPO). This figure reflects the average number of days it takes for a company to convert inventory or materials your company purchases to cash.
Two Types Of Conversion Cycles
Positive Cash Conversion Cycle
A positive cash conversion cycle occurs when a company takes longer to pay its suppliers than it does to sell its inventory and collect payment from its customers. This means that the company is able to use the funds from its sales to finance its operations while it waits to pay its suppliers. In this case, a low CCC indicates that the company can move inventory or materials quickly and efficiently, allowing it to generate cash flow more rapidly.
Negative Cash Conversion Cycle
A negative cash conversion cycle occurs when a company takes less time to pay its suppliers than it does to sell its inventory and collect payment from its customers. This means that the company is able to collect payment from its customers before it needs to pay its suppliers for the inventory or materials used to make those sales.
It is a strong indicator of a healthy business, as it means that the company is generating cash flow from its operations without needing to rely on external financing. However, it is important to note that a negative CCC is not always a good thing. While it may indicate that a company is efficient in its operations, it can also mean that the company is not taking advantage of opportunities to negotiate better payment terms with its suppliers. In some cases, a company may be able to negotiate longer payment terms with its suppliers, which would allow it to maintain a negative CCC while also improving its cash flow.
In general, a negative CCC is more desirable than a positive CCC because it indicates that a company is generating cash flow from its operations. This means that the company is able to finance its growth without needing to rely on external financing sources, such as loans or investments. It also means that the company is able to pay its bills on time and maintain good relationships with its suppliers, which can be important for long-term success.
FAQs About Cash Conversion Cycles
Ideally, you want a low cash conversion cycle to avoid cash flow issues. It reflects sound financial management and demonstrates that your company accurately predicts inventory needs, collects receivables by the due date, and has ample time to remit payments to vendors. However, what constitutes a “good” CCC can vary depending on the industry and the size of the company. For example, a company in a fast-moving consumer goods industry may have a lower CCC than a capital-intensive one. Ultimately, the goal for any company should be to continually improve its CCC and strive for the most efficient cash flow management possible.
It’s best to have a low or negative CCC. Otherwise, your company spends a substantial amount of time working to convert inventory to sales or collecting payments from customers in a timely manner. This often means you’ll encounter cash flow issues, which typically lead to financial instability.
By contrast, a low or negative CCC indicates that a company is able to convert its investments into cash flow quickly and efficiently, which can help improve its financial health and long-term success.
The cash conversion cycle has a direct impact on a company’s working capital. Working capital is the amount of money a company has available to pay its bills and fund its day-to-day operations. The longer a company holds onto its inventory, the more working capital it ties up in that inventory. This can lead to cash flow issues and make it difficult for a company to pay its bills on time.
The longer you have inventory in your possession, the more likely you will have minimal working capital on hand. But suppose your CCC is low, and you turn inventory into sales in a short period. In that case, your business is less likely to struggle with keeping the ample amount of working capital on hand needed to keep operations running smoothly.
How to Get an Influx of Cash to Grow Your Business
Whether you have a high or low CCC, there could come a time when you need the influx of cash to grow your business. In that case, a business loan could be worth considering. But with so many options available, maybe you aren’t sure where to start your search for funding.
When considering a business loan to get an influx of cash to grow your business, it’s important to do your research and explore all of your options. Here are some tips to help you get started:
- Determine your funding needs: Before you start looking for a loan, it’s important to determine how much money you need and what you’ll use it for. This will help you narrow down your options and find a loan that meets your specific needs.
- Research lenders: There are many lenders out there, from traditional banks to online lenders and alternative financing sources. Research different lenders to find the one that offers the best terms and rates for your business.
- Check your credit score: Your credit score will play a big role in whether you’re approved for a loan and what interest rate you’ll be charged. Make sure your credit score is as high as possible before applying for a loan.
- Gather your financial documents: Lenders will want to see your financial statements, tax returns, and other documents to determine your creditworthiness. Make sure you have these documents ready to go when you start applying for loans.
- Compare loan options: Once you’ve narrowed down your options, compare the loan terms and rates to find the best option for your business. Look for a loan with a low interest rate, flexible repayment terms, and no hidden fees.
- Apply for the loan: Once you’ve found the right loan, it’s time to apply. Make sure you have all of the required documents and information ready to go and be prepared to answer any questions the lender may have.
Getting an influx of cash to grow your business can be a great way to take your company to the next level. By doing your research and finding the right loan, you can get the funding you need to achieve your business goals and help build a solid financial foundation.
The Bottom Line
Ultimately, understanding the cash conversion cycle can help you identify areas where you can improve your business processes to increase cash flow and profitability. By monitoring this metric regularly, you can make informed decisions about when to invest in new inventory or equipment and when to adjust your pricing or payment terms to improve your cash flow.
