Cash Conversion Cycle

A cash conversion cycle shows how promptly a company sells its stocks and collects cash from customers. Learn its usage.
OPEN ACCOUNT
Cash Conversion Cycle
OPEN ACCOUNT
3 mins read
09-May-2024

The cash conversion cycle (CCC) is a popular fundamental analysis tool to assess a company’s cash flow management efficiency. It indicates how promptly a business is selling its inventory and collecting cash from its customers.

Let us understand the CCC in detail, determine its ideal value, and learn the calculation process.

What is the Cash Conversion Cycle (CCC)?

The cash conversion cycle is an analysis tool used to measure the efficiency of a company's cash flow management. It indicates how long it takes for a company to convert its investments in inventory and other resources into cash flows from sales.

The CCC is determined by summing:

  • The time it takes for a company to convert inventory into sales (Days Inventory Outstanding or DIO) and
  • The time it takes to collect payments from customers (Days Sales Outstanding or DSO)

From this sum, we subtract the time it takes to pay suppliers (Days Payables Outstanding or DPO). We can also summarise this information into a formula:

CCC = DIO + DSO - DPO

Want to explore more? Understand what free cash flows are and learn how cash flows differ from fund flows.

How do you calculate the cash conversion cycle?

The cash conversion cycle is effectively divided into three primary components. Let us learn how to calculate them and then obtain our CCC figures in four simple steps.

Step I: Determining days inventory outstanding (DIO)

  • Begin by determining the average inventory for the period
  • You can use the beginning and ending inventory balances
  • Alternatively, you can also take an average of inventory balances at different points in time.
  • Now, calculate the Cost of Goods Sold (COGS) for the period
  • This is usually found in the company's income statement
  • Use this formula

DIO = (Average Inventory)/(COGS ÷ 365)

  • This will give you the average number of days it takes for the company to sell its inventory.

Step II: Determining days sales outstanding (DSO)

  • Determine the average accounts receivable for the period
  • Similar to inventory, you can:
    • Use the beginning and ending accounts receivable balances or
  • Take an average
  • Calculate the total credit sales for the period.
  • This information is available in the company's income statement or financial reports.
  • Use this formula,

DSO = (Average accounts receivable)/(Total credit sales ÷ 365)

  • This will give you the average number of days it takes for the company to collect payment from its customers.

Step III: Calculate days payables outstanding (DPO)

  • Determine the average accounts payable for the period
  • Once again, you can use the beginning and ending accounts payable balances or take an average.
  • Calculate the total purchases made on credit during the period.
  • This information is also available in the company's financial statements.
  • Use this formula:

DPO = (Average accounts payable)/(Total credit purchases ÷ 365)

  • This will give you the average number of days it takes for the company to pay its suppliers.

Step IV: Calculate the cash conversion cycle

  • In this last step, we will now calculate the CCC
  • Use this formula

CCC = DIO + DSO – DPO

  • This will give you the company's cash conversion cycle.

How to interpret the cash conversion cycle?

Most investors interpret the CCC to check a company's:

  • Cash flow efficiency and
  • Working capital management

If we talk about an ideal CCC, there does not exist a universal CCC that applies to all companies. In reality, it varies across industries and depends on factors such as:

  • Business model
  • Operating cycle, and
  • Market conditions

Let us understand better by taking examples of FMCG and construction industries:

Fast-moving consumer goods (FMCG) industry

Construction industry

  • In the FMCG industry:

    • Inventory turnover is typically faster and

    • Payment terms are shorter

  • In such a case, an ideal CCC could be:

    • Closer to zero or

    • Even negative

  • In the construction industry, companies face longer production cycles that involve various stages, such as:

    • Planning

    • Design

    • Procurement of materials

    • Construction, and

    • Final inspection

  • Often, these multiple stages cause the payment terms to get extended.

  • These prolonged production cycles and extended payment terms result in a higher CCC, which is commonly accepted as ideal.


As per a general rule of thumb, a lower CCC is always desirable. It indicates efficient cash flow management and working capital optimisation.

High vs low cash conversion cycle

Parameters

High CCC

Low CCC

Meaning

A high CCC suggests that a company takes longer to convert its investments in inventory into cash from sales.

  • A low CCC shows that a company efficiently converts its investments into cash.

  • It collects payments from customers promptly and manages its payables effectively.

Indication

It indicates:

  • Inefficiency in operations

  • Slower inventory turnover

  • Extended accounts receivable collection periods, or

  • Delayed payments to suppliers.

  • It indicates:

    • Faster inventory turnover

    • Shorter accounts receivable collection periods, and

    • Optimised payment terms with suppliers

Effect

  • Companies with a high CCC often end up getting stuck in cash flow problems.

  • Such companies face liquidity challenges as a major chunk of their cash gets tied up in:

    • Inventory and

    • Receivables

  • Companies with low CCC can reinvest cash quickly.

  • They can seize growth opportunities and maintain a competitive edge in the market.

  • Furthermore, efficient working capital management helps in:

    • Improving liquidity

    • Reducing financing costs, and

    • Enhancing profitability


Conclusion

The cash conversion cycle (CCC) is often a part of fundamental analysis. It helps investors assess a company's cash flow efficiency and working capital management. CCC shows how long it takes for a company to convert inventory into cash flows from sales.

While a lower CCC is generally preferred, the ideal CCC varies across industries and depends on specific circumstances.

Do you wish to enhance your trading prowess? Learn about technical indicators today.

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Frequently asked questions

What are the 3 major components of the cash conversion cycle?
The three primary components of a cash conversion cycle are Time to Sell Inventory (Days Inventory Outstanding or DIO), Time to Collect Payment from Customers (Days Sales Outstanding or DSO), and Time to Pay Suppliers (Days Payables Outstanding or DPO).
Is a higher cash conversion cycle better?
No, a higher cash conversion cycle shows cash flow inefficiency and poor working capital management. Ideally, it should be low.
Are companies with low CCC good for making investments?
Yes, a low CCC indicates that the company promptly collects payment from its customers and has a short inventory cycle. Such companies are often in a position to reduce their financing costs and enhance profitability.
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